The Fallacy of Composition in the Modigliani/Miller Dividend Irrelevance Hypothesis

There is probably no more famous theory in Finance than Modigliani/Miller

Known as the Dividend Irrelevance Hypothesis it is that investors are not concerned with a company’s dividend policy since they can sell a portion of their portfolio of equities if they want cash.    By implication neither should a firm in determining whether to fund investment through debt or equity.

But a dividend is cash on hand, an equity is not it is a financial instrument unless an instrument is fully liquid and cash like they will always trade at different values.  The hypothesis only applies in ‘normal’times of liquid markets for equities and normal liquidity preference for money.

Let me illustrate with an example – lets say that every investor has an increased demand for liquidity.  It is like everyone trying to get cash out of a bank at the same time.  Firms with long term returns will have a less attractive weighted average cost of capital in those circumstances.  Investors would want to cash in dividends and either keep in cash or transfer to the safest haven with positive returns – such as bonds maybe. In these cases dividends will be more attractive than equities, so equities will be sold off and activist investors will pressure firms to return a greater proportion of profits to investors.

Now an argument against this point is that the shift in liquidity preference will shift interest rates, extra points if you spotted that, so higher interest rates will compensate in terms of the weighted cost of capital from the higher liquidity preference (im trying to keep this no mathematical – though do it yourself if you doubt me).  Good point but there is no guarantee of equality other than at times where all expected investments have expected returns.  In those cases such as financial crashes and day to day volatile unpredictable markets there will be a divergence leading to the weighted cost of capital either exceeding or undershooting the safe level of return.  Austerity can also shift the level of return from bonds.

What I hope this illustrates is the strong feedback loop the equity market provides to the wider economy at times of crisis.


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