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The Relationship between Dividend Payout and Firm Profitability

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Before the publication of Miller and Modigliani, the experts believed that the more the shareholders received in the form of a dividend, the higher the value of the company or corporation. The idea emerged from the extension of an already discounted profit approach in getting the firm's value. Miller and Modigliani (1961) critically analyzed the dividend policy in relation to the share price. They realized that the company’ s dividend policy does not have any correlation to the firm’ s value in perfect capital markets. They argued that the firm’ s current and future cash flows in the market (the choice of the company to invest in optimal projects) was the sole determinant of the firm’ s value. Analytically, the shareholders’ wealth is not affected by the dividend decision as had been proposed before.

In fact, the investors are naturally indifferent to the choices that they make in between capital and profits gains. Arguably, suppose the investors needed immediate cash they could just create their policy to sell their current shares in the capital markets (Miller & Modigliani, 1961). Their arguments, however, are based on various assumptions.

They assured of a perfect capital market and rational investors. Apparently, when firms pay more dividends, then they must offer less share appreciation price and provide the same amount of returns to the stockholders. In this view, the investors make the investments decisions from the cash flows. For this to work, capital and dividend gains taxed at the same rate must not exist. It means that there no tax advantage or disadvantage associated with the capital and dividend gain. M-M model is ideally based on the assumption of perfectly operating capital markets.

However, in reality, the world markets are imperfect. To evaluate the empirical evidence on this irrelevance theory, Black and Scholes (1974) relaxed the assumption of the perfect capital market. As such, they used the Capital Asset Pricing model to test the link between stock returns and dividend gains. In the Capital Asset Pricing Model, it is argued that the projected returns on any security or stock are strictly a function of its β .

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