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Relevance or irrelevance of retention for dividend policy irrelevance

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  • Magni, Carlo Alberto

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 clarifies and reinterprets DeAngelo and DeAngelo's result: Retention itself has not to do with dividend irrelevance, which holds even in case of retention. The key assumption has to do 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.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 5591.

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Date of creation: 04 Nov 2007
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Handle: RePEc:pra:mprapa:5591

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Related research

Keywords: Dividend policy; irrelevance; retention; zero-NPV; epistemology; agency theory;

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References

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  1. Jensen, Michael C, 1986. "Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review, American Economic Association, vol. 76(2), pages 323-29, May.
  2. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
  3. DeAngelo, Harry & DeAngelo, Linda, 2006. "The irrelevance of the MM dividend irrelevance theorem," Journal of Financial Economics, Elsevier, vol. 79(2), pages 293-315, February.
  4. Merton H. Miller & Franco Modigliani, 1961. "Dividend Policy, Growth, and the Valuation of Shares," The Journal of Business, University of Chicago Press, vol. 34, pages 411.
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Cited by:
  1. Carlo Alberto Magni & Ignacio Velez-Pareja, 2009. "Potential dividends versus actual cash flows in firm valuation," PROYECCIONES FINANCIERAS Y VALORACION 005516, MASTER CONSULTORES.
  2. Vélez-Pareja, Ignacio & Magni, Carlo Alberto, 2008. "Potential dividends and actual cash flows. Theoretical and empirical reasons for using ‘actual’ and dismissing ‘potential’, Or: How not to pull potential rabbits out of actual hats," MPRA Paper 7266, University Library of Munich, Germany.
  3. Magni, Carlo Alberto, 2007. "Residual income and value creation: An investigation into the lost-capital paradigm," MPRA Paper 6783, University Library of Munich, Germany.

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