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com/abstract=1328024

Extension of Dividend Policy, Growth, and the

Valuation of Shares by Miller and Modigliani (1961)

to Allow for Share Repurchases

Suresh P. Sethi

Charles and Nancy Davidson Distinguished Professor

Director, Center for Intelligent Supply Networks

School of Management, The University of Texas at Dallas

800 W. Campbell Rd., Richardson, TX 75080

sethi@utdallas.edu

Abstract

Miller and Modigliani (1961) consider valuation of innite horizon rms that

may not engage in purchasing their own shares. While their fundamental valuation

approach applies also to rms that purchase their own shares, their stream of

dividends approach does not apply to a class of rms paying out insucient

dividends as characterized by an if and only if condition in the paper. The latter

approach is modied so that it can be used for valuation of innite horizon rms

including those which may purchase their own shares. The modied approach is

the natural extension of the traditional dividend stream approach used for valuing

nite horizon rms. Moreover, it is proved to be equivalent to the fundamental

valuation approach.

Key Words: valuation, share price, dividend approach, cash ow approach, MM theory,

share repurchase

I thank Raymond Kan and Rajnish Mehra for helpful comments. Support from Social Science and

Humanities Research Council of Canada is greatly appreciated.

1

Electronic copy available at: http://ssrn.com/abstract=1328024 Electronic copy available at: http://ssrn.com/abstract=1328024 Electronic copy available at: http://ssrn.com/abstract=1328024

1 Introduction

In Section I of their seminal paper, Miller and Modigliani (1961), designated as MM

hereafter, provide a valuation formula for an innite horizon rm under the assumption

of perfect capital markets, rational behavior, and perfect certainty. The valuation is

based on the fundamental principle that the price of each share must be such that the

rate of return (dividend plus capital gains per dollar invested) on every share will be the

same throughout the market over any given interval of time.

In Section II of their paper, MM claim that a popular valuation approach called

the stream of dividends approach is equivalent to the fundamental valuation approach

used in Section I. It is important to point out that their proof of equivalence on pages

422-423 is incomplete in the sense that it proves only that the dividend stream approach

implies the fundamental approach and it does not prove the converse, namely, that

the fundamental approach implies the stream of dividends approach. Furthermore, we

should point out that while it is straightforward and perhaps the reason for MMs

omission of it to complete the proof when the rm may only issue new equity, the proof

is more complicated when the rm may also repurchase its own shares. More specically,

their dividend stream formula (13) needs to be subtly modied if the equivalence is to

be restored.

This note is devoted to developing a modied dividend stream approach of valuation

of rms including those which may engage in purchasing their own shares. It is then

shown that the modied approach is equivalent to the fundamental valuation approach.

In the next section, we describe the fundamental valuation approach of MM, which

applies to all rms under consideration. Section 3 shows that the traditional stream of

dividends approach as dened in MM does not extend to a class of rms that may pur-

chase their own shares. In Section 4 we provide the modied dividend stream approach

and prove its equivalence to the fundamental valuation approach. Section 5 concludes

the paper.

2

2 The Fundamental Valuation Approach

We begin by recalling the notation used by MM and by introducing some additional

notation. Let

d(t) = dividends per share paid by the rm during period t,

t = 0, 1, . . . ,

p(t) = the price (ex any dividend in t 1) of a share in the rm

at the start of period t,

n(t) = the number of shares of record at the start of t,

m(t + 1) = the number of shares (if any) sold during t at the ex

dividend closing price p(t + 1), so that

n(t + 1) = n(t) +m(t + 1),

V (t) = n(t)p(t) = the total value of the rm,

D(t) = n(t)d(t) = the total dividends paid during t, to holders of record at

the start of t,

E(t) = m(t + 1)p(t + 1) = the total equity capital raised during period t,

X(t) = the rms net prot for the period t,

I(t) = the rms investment in period t, and

= the required rate of return assumed to be constant for

simplicity in exposition; it will also be referred to as the

discount rate.

Using the fundamental principle of valuation

p(t) =

1

1 +

[d(t) +p(t + 1)] , (1)

some bookkeeping identities, and the transversality condition

1

(1 +)

T

V (T) 0 as T , (2)

3

MM obtain the value of the rm V (0) at time 0 to be

V (0) =

=0

1

(1 +)

+1

[X() I()] . (3)

Furthermore, it is easy to derive the value of the rm at time t as

V (t) =

=0

1

(1 +)

+1

[X(t +) I(t +)] ,

=

=0

1

(1 +)

+1

[D(t +) E(t +)] , (4)

and the number of outstanding shares and the share price as

n(t) = n(0)

t1

=0

_

1

E()

V ( + 1)

_

1

, p(t) =

V (t)

n(t)

. (5)

Before proceeding to the next section, let us note that the derivation of formulas (3)

and (4) do not depend on the sign of m(t + 1) or of E(t). Thus, if we were to interpret

a negative value of m(t + 1) as repurchase of m(t + 1) shares by the rm for a total

price of E(t) = m(t + 1)p(t + 1), all we have to do in Section I of the MM paper is

to assume

m(t + 1) n(t), (6)

so that the number of remaining shares at n(t + 1) = n(t) + m(t + 1) remain positive.

Note that m(t +1) = n(t) would imply a liquidation of the rm with the consequence

that V (t + 1) = 0.

Since the derivation of the formula of the rms value does not depend on the sign of

m(t +1) or of E(t), the economic proposition of the irrelevance of dividend policy, given

the investment policy continues to hold, not surprisingly, regardless of whether equity is

issued or retired.

3 The Stream of Dividends Approach and Share Re-

purchase

While the fundamental valuation approach in Section I of the MM paper holds regardless

of whether m(t+1) is positive or negative, the dividend stream approach runs into trouble

4

when m(t + 1) may take negative values. Before proceeding further we recall that MM

dene the dividend stream approach by their equation (13), which is

p(t) =

=0

d(t +)

(1 +)

+1

(7)

along with the bookkeeping identities (5) and the transversality condition (2).

Let us try to complete the omitted part of MMs equivalence proof by starting with

the fundamental approach (1) and see if we can end up with (7). By recursion of (1), it

is easy to obtain

p(t) =

T1t

=0

d(t +)

(1 +)

+1

+

1

(1 +)

T1t

p(T). (8)

Using (4) and the relation V (T) = p(T)n(T) in (8), we obtain

p(t) =

T1t

=0

d(t +)

(1 +)

+1

+

1

(1 +)

T1t

V (T)

n(T)

. (9)

Taking the limit as T , we obtain

p(t) =

=0

d(t +)

(1 +)

+1

+ lim

T

1

(1 +)

T1t

V (T)

n(T)

. (10)

Clearly, if m(t + 1) 0 for all t, the limit in the second term of the RHS of (10)

would vanish on account of (2) and n(T) n(0) > 0, and MMs equivalence proof would

be completed in the case of no share repurchase.

But if the rm engages in share repurchases, n(T) n(0) > 0 can no longer be

guaranteed and the equivalence would hold if and only if the limit term on the RHS

of (10) would vanish. At this point, it would be worthwhile to provide two examples

illustrating why the limit might not vanish in all cases of rms with repurchases allowed,

the cases of rms that have already been valued by the fundamental valuation approach.

Example 1. Firm 1 never pays any dividend but repurchases its own shares. More

specically, let

n(0) = 2, D

1

(t) = 0, (1 )

t

E

1

(t) =

_

1

2

_

t

.

5

Then using (4), we obtain V

1

(t) = (

1+

2

)

t1

. It is then easy to show that n

1

(t) = (

1

2

)

t1

and P

1

(t) = (1 +)

t1.

Note that (1 + )

t

V

1

(T) =

1

1+

(

1

2

)

T1

0 as T 0, so that the transversality

condition (2) is satised. On the other hand, the second term on RHS of (10) is strictly

positive, i.e.,

lim

T

1

(1 +)

Tt

V

1

(T)

n

1

(T)

= (1 +

t1

) > 0. (11)

Example 2. Firm 2 pays a positive dividend and repurchases shares. More specically,

n

2

(0) = 1, (1 +)

t

D

2

(t) = (

1

2

)(

1

4

)

t

, (1 +)

t

E

2

(t) =

1

2

_

(

1

4

)

t

(

1

2

)

t

_

.

Then, it can be shown that

V

2

(t) = (1 +)

t1

(

1

2

)

t

, n

2

(t) =

t1

=0

_

1

2 (

1

2

)

_

,

and

p

2

(t) = (1 +)

t1

t1

=0

_

1 (

1

2

)

+1

_

.

Once again the transversality condition (2) holds for V

2

(T). Furthermore, the second

term on the RHS of (10) is strictly positive, i.e.,

lim

T

1

(1 +)

Tt

V

2

(T)

n

2

(T)

= (1 +)

t1

=0

_

1 (

1

2

)

+1

_

0.2887881(1 +)

t1

> 0. (12)

Let us make the following observations. Whereas Firm 1 pays no dividend and Firm

2 does, the limit in the second term of the RHS of (10) does not vanish for either.

For both rms, it can be easily shown that n

1

(t) 0 and n

2

(t) 0 as t . The

observation that there are no outstanding shares in the limit might lead one to believe

that these rms are not realistic in some sense. The fact of the matter is that these

rms are just as realistic as any other innite horizon rm. To see this, let us rst note

that n

1

(t) > 0 and n

2

(t) > 0 for every t. Second, it is easy to introduce stock splits so

that the number of outstanding shares do not approach zero as t . For instance, a

two-to-one stock split in each period t = 0, 1, 2, . . . , in Example 1 before any repurchase

6

will make the before-split number of shares n

1

(t) 2 as t and the after-split

number of shares to twice as many. What is of essence in Examples 1 and 2 is that the

residual share price at innity does not vanish. As we shall see below, these rms are

giving dividends that fall short in relation to their respective valuations, and as a result

there is a positive residual share price at innity. If there were a residual liquidation

value of a nite horizon rm, no one would question the presence of the terminal term

in the share price equation (9). What most people nd hard to believe is that this can

happen also in the case of an innite horizon rm depending on its dividend and equity

repurchase policies.

The natural question that arises is how to characterize rms policies D(t) and

E(t), t = 0, 1, . . . , for which the limit term on the RHS of (10) vanishes. Sethi, Derzko

and Lehoczky (1992) have studied this question. In the present context, they show that

lim

T

1

(1 +)

T1t

V (T)

n(T)

= 0 i

=0

D()

V ()

= , (13)

where we recall that V (t), t = 1, 2, . . . , is known by formula (4) given D(t) and E(t), t =

0, 1, . . . . Note that the dividend yield in each period is a ratio of two quantities with

dollar units, it does not require discounting when we sum these ratios over the innite

horizon.

Because of this complete characterization via a necessary and sucient condition,

there is no escaping the conclusion that the second term on the RHS of (10) will not

vanish i

=0

D()

V ()

< , i.e., the sum of the dividend yields is nite. Thus, a rm

may be considered to be paying sucient dividends in relation to its valuation if

=0

D()

V ()

= and to be paying insucient dividends in relation to its valuation if

=0

D()

V ()

< . Furthermore, it is shown in Sethi (1996) that dividends are insucient

if a share in the dividend reinvestment plan grows to only a nite number of shares at

innity. Moreover, our task in this paper is to value all possible rms including those

in Examples 1 and 2 that pay insucient dividends. Clearly, the fundamental valuation

approach applied to such rms cannot yield the share price formula (7). It is imperative,

therefore, to modify the traditional stream of dividends approach so that it can be made

7

equivalent to the fundamental valuation approach. This is carried out in the next section.

4 The Modied Dividend Streams Approach and

Proof of Equivalence

We begin with a discussion of Example 1. Since there are no dividends to be paid out,

and since the share price using the fundamental approach is strictly positive, could we

consider the share repurchase as a form of dividend? If yes, the problem is that in any

given period it cannot be distributed to every stockholder of record at the beginning of

the period, except if it were a liquidating dividend.

Since an innite horizon rm is only a model that represents a rm with a large but

unknown nite horizon, let us rst examine what would happen to our rm, if it were

to decide to distribute a liquidating dividend in some period T. Clearly, the share price

p(t) will be given by the formula (9), where the second term on the RHS is nothing but

the liquidating dividend. As T increases, the formula continues to hold good. In other

words, p(t) dened in (9) remains the same no matter when the liquidating dividend is

paid out, as long as the amount of the dividend in period T is

V (T)

n(T)

determined for each

T in Section 2 by using the fundamental approach. Clearly p(t) will remain the same if

we take the limit of the liquidating dividend in (9) as T and obtain (10), which

we rewrite as

p(t) =

=0

d(t +)

(1 +)

+1

+ (1 +)

t1

, (14)

where the limiting per share liquidating dividend

= lim

T

1

(1 +)

T

V (T)

n(T)

. (15)

Now if we limit ourselves only to the fundamental valuation approach, we obtain the

value V (t) of the innite horizon rm in formula (4) and the share price in (5) or (14),

and there is nothing more to be done.

But if we are to develop the modied dividend stream approach and show it to be

equivalent to the fundamental approach, there is no alternative but to take a clue from

8

(9) and dene

p(t) = lim

T

_

T1t

=0

d(t +)

(1 +)

+1

+

1

(1 +)

T1t

V (T)

n(T)

_

, (16)

where V (t) is assumed to be not known and is to be obtained by using (16), (2), and (5),

which we shall refer to as the modied dividend approach in contrast to the traditional

dividend approach dened by (7), (2) and (5).

From the earlier discussion, one could interpret (16) to be the share price of a rm

that would eventually distribute an appropriate liquidating dividend to be determined.

We can now prove the following result.

Theorem 4.1 The modied dividend stream approach dened by (16), (2) and (5) is

equivalent to the fundamental valuation approach dened by (1), (2) and (5).

Proof. Since (10) was obtained by the fundamental approach, it is immediate that the

fundamental approach implies (16) but not (7) in general and, therefore, the modied

dividend stream approach.

To go the other way, it is easy to see from (16) that

p(t) =

1

1 +

p(t + 1) = lim

T

_

T1t

=0

d(t +)

(1 +)

+1

T2t

=0

d(t + 1 +)

(1 +)

+2

_

=

d(t)

1 +

, (17)

which is nothing but (1). This completes the proof since relations (2) and (5) are common

to both approaches. 2

That (16) is the correct replacement as well as generalization of (7) should come as

no surprise. After all, for any nite horizon rm with horizon T, formula (9) denes the

dividend approach where V (T) denotes the total liquidating dividend in period T. The

value V (T +1) of the rm in period (T +1) is identically zero in this case. The natural

extension of these two ideas for an innite horizon is clearly (16) and the transversality

condition (2), and not (7) and (2) as in MM.

Sethi, Derzko, and Lehoczky (1992) even go further and show that the traditional

dividend stream approach dened by equations (7), (2), and (5) does not have any

9

positive solution V (t), p(t) and n(t) that satises all three equations if

t=0

_

D(t)

=t

{D() E()}

_

< .

5 Concluding Remarks

In this paper, we have extended the MM framework to allow for rms that may purchase

its own shares. We showed that the traditional dividend stream approach as formulated

in MM breaks down for a class of rms. Such a class was completely characterized in

Sethi, Derzko and Lehoczky (1992) and Sethi (1996). We developed a modied dividend

stream approach as a natural generalization of the dividend stream approach for nite

horizon rms. We proved that the modied dividend stream approach is equivalent to

the fundamental valuation approach.

Furthermore, using the analysis of Sethi, Derzko and Lehoczky (1992) carried out in

a general stochastic environment, the ideas and the results of this paper can be extended

to general stochastic environments.

References

Miller, M.H. and Modigliani, F. (1961). Dividend Policy, Growth and the Valuation of

Shares. J. Business, 34(34): 411-433.

Sethi, S.P., Derzko, N. and Lehoczky, J. (1992). A Stochastic Extension of the Miller-

Modigliani Framework. Mathematical Finance, 1(4): 57-76.

Sethi, S.P. (1996). When Does the Share Price Equal the Present Value of Future

Dividends? - A Modied Dividend Approach, Economic Theory, 8: 307-319.

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