Modigliani and Miller vs Gordon and Lintner: Dividend Policy Relevance Debate

The Importance of Dividend Policy in Financial Decision Making

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Question

Modigliani and Miller (MM) argued that dividend policy is irrelevant. On the other hand, Gordon and Lintner (GL) argued that dividend policy does matter. GL's argument rests on the contention that

Answers

A. most investors will reinvest rather than spend dividends, so it would save investors money (taxes) if corporations simply reinvested earnings rather than paid them out as dividends.

B. k(s) = D1/P0 + g is constant for any dividend policy.

C. none of the answers are correct.

D. investors, because of tax differentials, value a dollar of expected capital gains more highly than a dollar of dividends.

E. because of perceived differences in risk, investors value a dollar of dividends more highly than a dollar of expected capital gains.

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Explanations

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A. B. C. D. E.

The main conclusion of MM's irrelevance theory is that dividend policy does not affect the required rate of return on equity. Gordon-Lintner disagreed stating that k

(s) decreases as the dividend payout is increased because investors are less certain of receiving the capital gains which should result from retaining earnings than they are of receiving dividends. They said that investors value expected dividends more highly than expected capital gains because the dividend yield is less risky than the growth component in the total expected return equation, k(s) = D1/Po + g. MM disagreed and theorized that k(s) is independent of dividend policy, implying that investors are indifferent between dividends and capital gains.

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