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Perfect-Market Irrelevance

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Similar to their proposition on capital structure irrelevance, professors Modigliani and Miller also propounded a theory on the irrelevance of corporate dividends, which implies that in a perfect market, dividends have no effect on market value of a firm. From the owner’s perspective, the payout of dividends is a mere reorganization of the firm’s money from the cash reserves to the investor; it has no impact on the value of the firm and he himself is neither richer nor poorer for it.

The investor on his part can also control his return on shares irrespective of the dividend policy. He can buy more shares if the dividend is too big or sell shares if the dividend is too small to get a similar cash flow.

So the only thing he cares about, with respect to the firm’s value is its earnings which would be a function of the firm’s investment and borrowing policies. It would take an exceptional case like the Studebaker Corporation which had payout ratios of 500% and 350% in 1930 and 1931 – eventually entering receivership – for dividends to have an impact on a firm’s value.

Today’s practical scenario is reflected by the fact that the yearly S&P 500 dividend yield shows an average of 1.99% between 2009 and 2015. And there is only little to be earned by an investor if he takes over the firm and rectifies the dividend policy.

Only in a scenario like Studebaker would the destruction caused by the dividend policy justify the transaction costs for an investor, like it did for the Lehmann brothers who refinanced the firm and brought it back to profitability.

The M&M model implicitly defines these aberrations from and the perfect market clauses like “no transaction costs” which must exist for the dividend policy to eventually matter. In the same context, we can see that in the real world, firm’s value rises or falls in proportion to the increase or decrease in dividend, as it is considered to be a statement of the firm’s credibility or future prospects.

This too can be seen as a result of an aberration from the perfect information clause as the owners and managers almost always have more information than the investors. However, the assumption of a perfect market can be used to dismiss a few myths and answer some related questions in the investor’s mind.

Do dividends protect my principal investment vis-a-vis selling my shares?

Does the profit from share buybacks roll out only to the tendering shareholders?

Do buybacks increase the Earnings per Share?

The answer to all these questions is “NO”. But let’s go into details one at a time.

  • Assume that you have invested $1000 at $5 per share. If you get a dividend of $1 per share, you will get a cash flow of $200 and own $800 worth of shares, after adjustment of the share price. On the other hand, if you haven’t got a dividend, you could sell 40 shares and get your $200; you would still own 160 shares of $800 value. So in terms of total value, your investment would remain the same. It directly indicates that “investment substance” does not have exact impact of dividends, but selling shares have this.
  • To answer the second question, it is sufficient to say that unless the buyback happens at unfair prices, which could be the case when the company is trying to ward off potential takeover bids. It is another way, just like a dividend payout, of reorganizing the firm’s money. What does this mean practically? Let’s go back to the scenario we used to answer the first question. Instead of paying a dividend of $1 to 100 investors (including you), who have equal investment in the firm, the company bought back shares worth $20,000. This goes to the tendering investors in the form of cash.

The firm value will now be $80,000 but the number of shareholders reduces to 80. So you still have $1000 worth of shares. Like matter in the universe, money has merely been rearranged in this financial microcosm. In a long-term perspective, however, with the reduced number of shareholders, you do end up having a bigger chunk of the pie.

  • Lastly, the relation between buybacks and EPS is not as simple a math as it looks on the surface. It is easy to think that a reduction in outstanding shares would automatically increase the EPS. But we have to factor in the “income from continuing operations” and whether that is affected by how the buyback is financed, say or if the same cash could have been used for more profitable projects. Selling your cash cow to finance a buyback would, for example, have a negative impact on the earnings and consequently on the EPS. Idle cash, sitting in the company’s reserves can be better invested in buybacks rather that in low net worth projects and this would definitely have a positive impact on the EPS.

While answering these questions, we have of course considered a perfect market, where the bottom line is good investments and earning. Most of these scenarios are likely to be replicated in the real world as well.

However, since the assumptions associated with a perfect market are not in force, we have to factor in various forces and delve deeper into the real process. For example, while answering the question on dividends vs. selling shares, we have to factor in the taxes on dividends or the transaction cost of selling the shares. Similarly, buyback of shares can lead to managerial discretion or reduce agency costs associated with retaining cash, thus leading to higher EPS.

Perfect market and financial market are closed and in real life too it is completely perfect. However, in case of imperfect market, the things are not so closed an imperfect in all ways. Retail investors just get or receive dividends who desire spending their money. The possibility of saving of transaction cost is there in case they are unable to sell shares. So, in this case share repurchase does not take place. Here, it is not much important to know that from where the money comes.

Share repurchase as well as dividends in perfect market can be thinking easily. Only if there is no tax, then the shareholders have the equal status without or with a dividend payment or a repurchase. Thus, with all projects together the NPV value is positive. Positive side total worth of the projects and the firm’s value are equal. Just like a perfect market it is also important to understand the exact value of these in imperfect market.

Questions:

  1. When a perfect market condition is considered and it is found that a particular investor cannot directly be a part of that share repurchase programs, in that case is it possible that repurchasing of shares is done via the dividend payout program?
  2. How do repurchasing of shares result in influencing of eps system of a particular company
  3. When a particular company has close to 80 shares, and any person owns 20 of them, in that case the person is trying to fire the management. But now the management decides to buy the $10 shares at an amount of $15. So, what will be the total value of repurchased shares?

 

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