However, critics overplay their hand when they invoke M&M in support of the blanket proposition that dividends are irrelevant. It is time to deflate that bubble and set the record straight: Modigliani and Miller did not say that dividends were irrelevant.
What M&M said was something that was much more qualified than that. Clearly comprehending exactly what they said and did not say can serve as an important first step in understanding whether dividends matter.
What Did Modigliani And Miller Really Say About Dividends
In order to answer the question regarding exactly what M&M really said about dividends in their seminal paper, I will quote Merton Miller himself:
We argued in our paper that if you hold constant the use represented by the firm’s capital budget, that is, its investment spending, then paying out more dividends just means you will have to raise more funds from bank loans or outside flotations of bonds or stocks. A firm’s choice of dividend policy, given its investment policy, is thus really a choice of financing strategy. Does the firm choose to finance its growth by relying more
heavily on external sources of funds (and paying back some of those funds in higher dividends) or by cutting its dividends and relying more heavily on internal funds?
Put this way, it is by no means obvious that the generous dividend/heavy outside financing strategy is always the best one, or vice versa. In fact, when we academics say that dividend policy doesn’t matter much, we are really saying only that, given the firm’s investment policy (which is what really drives its engine), the choice of dividend/financing policy will have little or no effect on its value. Any value that the stockholders derive from the higher dividends is more or less offset, because they must give outsiders a bigger share of the pie.
On many occasions and in various forums, Merton Miller was very careful to qualify the claim that “dividend policy doesn’t matter much.” The key qualification is that dividends are irrelevant to the extent that the cash used to pay dividends would increase the amount of debt or equity capital that the firm would have to raise in order to implement its investment program.