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Dividend Irrelevancy
The Dividend Irrelevancy Proposition of Franco Modigliani and Merton Miller demonstrates that the value of the corporation will be independent of the dividend payout ratio adopted by its managers, so long as this does not affect their implementation of its optimal level of capital expenditure each period. The higher the ratio, the higher the yield the stock will trade on, but this is of no consequence to the rational stockholder. By buying and selling in the market, she can make her own determination as to how much spending money she wants to realise year by year, and how much of her portfolio she wants to remain invested for the future. The Proposition has then been interpreted to mean that the search for an optimal payout ratio for the corporation is futile.
Market Value Added
But the Proposition rules nothing out either. In particular, the managers can hardly be faulted if their payout ratio is consistent with the optimal stewardship of the corporation’s resources. In the present study, the managers’ decisions are determined with the objective of maximising the market value added (MVA) of the corporation: this is the excess of its enterprise value over the book cost of its capital employed. Enterprise value is the total market capitalisation of the corporation’s debt and equity, with the latter determined as the present value of the residual net free cash flow to be distributed year by year in the future.
Decision Variables
Under fairly straightforward assumptions concerning the expansion in the corporation’s investment opportunity over time – this is modelled as a steady rightward progression in its marginal efficiency of capital expenditure curve (MEC) – and the stability of its borrowing arrangements, there are two rules to be followed. Firstly, the corporation should adopt that gearing ratio (debt to enterprise value) that minimises its market value weighted average cost of capital (WACC). Secondly, its capital expenditure should be set at that amount each year such that the MEC (for that year) falls to that level where it is equal to the WACC, now treated as a perennial constant. It should thus undertake only those projects with positive net present value (NPV).
Steady State Growth
The picture that emerges is then of the corporation moving along a steady state growth path. Each of its accounting and stock market magnitudes grows at a common constant rate. Each of its accounting and stock market ratios, including its payout ratio, remains constant through time. The assumption of stable borrowing costs implies that the corporation’s debt will trade at face value: coupons will be discounted at the interest rate it pays. The further assumption necessary to generate this result is that the corporation distributes to its stockholders its residual net free cash flow – that is, the cash it has available after implementing its optimal capital expenditure plan each period, as determined above.
Optimal Payout Ratio
While the payout ratio thus arrived at is not a decision variable of the model – for instance, in the way described above for the optimal gearing ratio – it does have the following attributes:
1. it results from an optimisation process
2. it provides a valid prediction of how the well-managed corporation may be expected to behave in relation to its distribution policy: the corporation simply pays out the portion of its earnings it can afford after prioritising its investment spend each period.
It is important to stress that neither the payout ratio, nor its complement, the retention ratio, appears explicitly in the model.
Personal Taxes
The analysis described above is satisfactory to the extent that all investors are subject to the same taxes. This is not the same as being subject to the same tax regimes. In the UK and the US, pension funds (and some other institutions) pay no tax. The main contrast is then with those private individuals who are subject both to the higher rate of income tax on the dividends they receive, and to capital gains tax if and when they realise investment profits. This means that a corporation that wishes to maximise its MVA should distribute its residual net free cash flow by implementing a series stock repurchase programmes. In this way, all stockholders will be able to avoid paying income tax. Further, those stockholders who retain their shares will, other things being equal, benefit from an equivalent appreciation in the value of their investment in the corporation. Again, they will be able to avoid any liability to capital gains tax. Ironically, it is the Dividend Irrelevancy Proposition that indicates that it would be illogical for the gross funds to object to the repurchase procedure, even though it will only be those individual stockholders subject to the higher rate of income tax who stand to benefit from it directly.
Distributions from Year to Year
Part of the problem of implementing the insights from the model in practice arises because corporations have to decide their payouts from year to year in the light of earnings and cash balances that fluctuate with the economic cycle and other commercial pressures. This means that any assessment of the consistency of the corporation’s payout ratio with its optimal level has to be averaged over a reasonable period of time. The model then shows that its retention ratio - the complement of its payout ratio - should be equal to the ratio of its underlying growth rate to its return on equity. However, for this test to be meaningful, return on equity has to be evaluated on the assumption that the corporation is pursuing its optimal financing and investment policies as stated above. Thus, the model represents an important planning tool for chief financial officers when they are faced with making recommendations on distributions to their boardroom colleagues, and indeed, more generally, when they are plotting their financial strategy.
P-E Ratio versus Growth
The central simulation demonstrates how the characteristics of the corporation vary with the growth rate. Corporations growing at rates between zero and 9% are portrayed, and the dividend discount model indicates that the residual net free cash flow yields on their shares will decline linearly over this range. This drives a significant escalation in their respective price-earnings (P-E) ratios, which in turn, is reflected in very high equity market capitalisations for the fastest-growing cases, and thereafter, correspondingly high enterprise values. Investment analysts and other financial practitioners concerned with valuing companies will find the new insights offered by the study into the trade-off between P-E and growth to be of major significance for their craft.
Payout versus Growth
The zero growth corporation makes no investments, and its payout ratio will therefore be 100%. Surprisingly, possibly, the corporation growing at 9% also manifests a high payout ratio – more than two thirds. In between – at 8% growth - the ratio dips to only about one third. The faster the corporation grows, the more it will need to spend on capital expenditure, and therefore the greater the percentage of earnings it will, in general, retain to finance the saving and investment process. However, as the growth rate increases, so equity market capitalisation escalates and an increasing proportion of the capital expenditure is thus capable of being financed with debt. Eventually the payout ratio starts to increase again, and ultimately reverts back to the higher levels – indeed, even possibly reaching 100%.
Corporation Tax versus Growth
Ignoring personal taxes as argued above, the model shows that the escalation of enterprise value with the rate at which the corporation grows is supported by a dramatic decline in the overall effective tax rate. Firstly, increasing reliance on debt finance reduces the corporation tax liability – the tax shield effect. Secondly, stockholders receive an increasing proportion of their return in the form of tax-free capital appreciation – assuming always that no potentially taxable gains are realised. Earnings used to finance the repurchase programme and the equity component of capital expenditure will have suffered corporation tax, of course - in the simulations, at the forthcoming UK rate of 28% - but for the fastest growing company tax free capital appreciation from year to year becomes substantial. Retentions fall away dramatically, and the effective corporation tax levy works out at less than 5% in the case of 9% growth.
Arbitrage Pricing
Obviously such effects are not lost on the stock market. All the corporations in the simulation are priced to generate the same total rate of return - the equity cost of capital (ECC) – which eventuates at 10.25%: this too is determined within the model. There are thus no arbitrage opportunities between the companies in the simulations, even though they manifest highly contrasting optimal payout ratios, with correspondingly contrasting yields.
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