Abstract. In an interesting recent paper, DeAngelo and DeAngelo (2006) highlight that Miller and Modigliani’s (1961) proof of dividend irrelevance is based on the assumption that the amount of dividends distributed to shareholders is equal or greater than the free cash flow generated by the fixed investment policy. They claim that, if retention is allowed, dividend policy is not irrelevant. This paper shows that the dividend irrelevance proposition holds even in case of retention. The key assumption has not to do with retention but with the NPV of the extra funds (either retained or raised): if NPV is zero, dividend irrelevance applies. Yet, the dichotomy retention/no-retention is useful, because if agency problems are present, managers tend to retain funds and invest them in negative-NPV projects, and therefore the zero-NPV assumption must be removed, so that dividend irrelevance does not apply any more. Keywords. Dividend policy, irrelevance, retention, zero-NPV, epistemology, modelling, agency theory. JEL codes. B41, G12, G30, G31, G35.

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Relevance or irrelevance of retention for dividend policy irrelevance

Introduction

A firm’s value is given by the sum of the present value of forecasted cash flows. Resting on Miller and Modigliani’s (1961) dividend irrelevance proposition, practitioners and some academics do not use actual cash flows; rather, they discount potential dividends, also known as free cash flows or free cash flows to firm (e.g. Damodaran, 2006a,b; Colepand, Koller and Murrin, 2000). Magni and Vélez-Pareja (2009) support the idea that only actual cash flows should be discounted, whereas potential dividends distort valuation in all cases where excess cash retained is not invested in NPV-neutral investments. In an interesting recent paper, DeAngelo and DeAngelo (2006) revisit Miller and Modigliani’s (1961) paper on dividend policy irrelevance and claim that dividend policy is not irrelevant (see also DeAngelo and DeAngelo, 2007). In the 2006 paper, DeAngelo and DeAngelo (DD) underline the fact that Miller and Modigliani (MM) assume that 100% or more of the free cash flow is distributed to shareholders, thus shunting aside the possibility of retention. According to DD, the assumption of no-retention made by MM makes dividend irrelevance a “meaningless tautology” (p. 306). If retention is allowed, then dividend policy is relevant, because managers could choose suboptimal policies by investing in non-zero NPV projects. This paper shows that relevance or irrelevance of dividend policy has not to do with retention; it has to do with the rate of return of the extra funds (excess cash) used for reinvestment or financing: dividend policy is irrelevant if and only if zero-NPV activities are undertaken, with or without assumption of retention. The dichotomy retention/no-retention is nevertheless useful, if it is reinterpreted as a regard for agency problems.

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The paper is structured as follows. • Section 1 A formal unambiguous definition of dividend policy irrelevance is given It is proved that dividend policy irrelevance holds if and only if the extra activities are zero-NPV activities. Therefore, MM’s thesis extends to the retention case It is shown that MM’s assumption of fairly priced stocks is (sufficient but) not necessary for dividend irrelevance It is underlined that the case of retention give managers full control on shareholders’ wealth, as opposed to the case of no-retention • Section 2 DD’s definition of dividend irrelevance is shown to be unnecessarily rigid and based on semantic conventions. While not all feasible dividend policies are optimal, all feasible dividend policies are optimal if the zero-NPV assumption is made (regardless of retention)...