Original Miller and Modigliani (1961) & Communicate Information to Shareholders Management Assignment Help

Assignment Task

Introduction 
Why do some firms pay dividends while others do not? Since the publication of the 
original Miller and Modigliani (1961) irrelevance propositions, this question has puzzled 
financial economists. Traditionally, finance scholars have emphasized explanations for 
dividends that are based on the desire to communicate information to shareholders or to satisfy 
the demand for payouts from heterogeneous dividend clienteles [see Allen and Michaely’s 
(2003) survey]. Recently, however, DeAngelo, DeAngelo, and Skinner (2004) cast doubt on 
signaling and clientele considerations as first-order determinants of dividend policy by reporting 
that dividends in the U.S. are increasingly concentrated among a small number of large payers. 
 An alternative view of dividends, proposed by DeAngelo and DeAngelo (2006), is that 
optimal payout policy is driven by the need to distribute the firm’s free cash flow. They propose 
a life-cycle theory that combines elements of Jensen’s (1986) agency theory with evolution in the 
firm’s investment opportunity set of the type discussed in Fama and French (2001) and Grullon, 
Michaely, and Swaminathan (2002). In this theory, firms optimally alter dividends through time 
in response to the evolution of their opportunity set. The theory predicts that in their early years, 
firms pay few dividends because their investment opportunities exceed their internally generated 
capital. In later years, internal funds exceed investment opportunities so firms optimally pay out 
the excess funds in order to mitigate the possibility that the free cash flows will be wasted. 
Consistent with this life-cycle view, DeAngelo, DeAngelo, and Stulz (2006) find that the 
propensity to pay dividends is positively related to the ratio of retained earnings to total equity, 
their proxy for the firm’s life-cycle stage. 

Yet a further wrinkle in the ‘dividend puzzle’ literature is presented in Fama and French 
(2001). Fama and French report a substantial decline in the proportion of firms paying dividends 
in the U.S. Although this decline is due in part to changes in the characteristics of firms that are 
publicly traded (i.e. more firms exhibit characteristics similar to those of non-dividend-paying 
firms), Fama and French nonetheless report that once they control for these characteristics, they 
still find a significant decline in the residual propensity to pay dividends. This evidence poses a 
further challenge to dividend theories in so far as candidate theories should be able to explain 
time series changes in the propensity to pay dividends

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