MM’s dividend irrelevance theory holds that in a no-tax/no-fees world, dividend policy is irrelevant since it has no effect on the price of a firm’s stock or its cost of capital, because individual investors can create their own homemade dividend,
Comment:
The homemade dividend is created by selling a portion of your shares to generate cashflows. This would be “equivalent” to a dividend.
However…
I dont quite get this statement. So let’s say you have one (1) share. You mean to say that you having a share and a dividend from that share is equal to just liquidating and not having the potential to earn in the future? Can someone help me with this?
I would still rather keep my share and continue earnings in dividends than selling out entirely and have no potential to earn anymore. I dont understand how earnings in dividends is equivalent to you creating homemade dividends by selling your share. What if next quarter, you have no shares to sell? If you held on to it, you would have earned a dividend.
The idea is that you have, say, 1,000 shares. Instead of the company giving you a 5% dividend, you sell 50 shares (= 5% × 1,000 shares). If you own only 1 share, you would sell 0.05 shares.
Because the dividend will (likely) never be 100%, you will never sell all of your shares.
But if you have 1 share, you can’t sell a portion of that one share. That’s what confuses me. I feel like you selling shares is not a long term solution since eventually you will run out, while with dividends, you get to keep your shares and keep earnings, with the potential to sell ALL shares.
You can look at the M&M theories (on capital structure and dividends) as “base cases”. In a “perfect” world (no taxes, no financial distress, no trading frictions, perfect information, etc) what you choose doesn’t matter. That’s why they’re called “irrelevence” theories.
This “perfect world irrelevence” perspectives was likely the beginnign of the modern field of finance. It set up a framework for future research: if in the perfect work capital structure or dividend changes don’t matter, but in our world they do, then which of the conditions don’t hold?
So, a multitude of studies went like this - how do variations in (fill in the violation of the M&M assumption here) affect the market reactions to a change in dividends? As examples, we can look at taxes (the tax law change a few years back), or information (what happens with dividend initiations for neglected vs. followed firms), and so on.
At this point, that approach is pretty played out. But there were a metric butt-load of studies like this in the 80s and 90s.
One more thing: let’s say that in an imaginary world this is true. So if you are indifferent, this means that the total amount of shares you hold diminishes and this is equivalent to you holding a share and receiving dividends?
Also, since you are constantly liquidating this portion, the amount of liquidiations are infinite, and the eventual amount will be very small (compared to you holding a share and earnings dividends).
Sorry to keep asking about this but I’d rather understand this fully than just memorize.
The idea is that you have, say, 1,000 shares. Instead of the company giving you a 5% dividend, you sell 50 shares (= 5% × 1,000 shares). If you own only 1 share, you would sell 0.05 shares.
Because the dividend will (likely) never be 100%, you will never sell all of your shares
So that means that 5% liqudiitation will be 5% of a smaller amount to infinity (and extremely small). While you holding a share and earning dividends will be much higher because share value remains the same.