THE JOURNAL OF BUSINESS indeed be the case. Specifically, if I( once you think of it. "It is, after all, is the given level of the firms invest- merely one more instance of the genera ment or increase in its holding of physical principle that there are no "financial il- assets in t and if X( is the firms total lusions""in a rational and perfect econom- net profit for the period, we know that ic environment. Values there are deter- the amount of outside capital required mined solely by "real"considerations- will be in this case the earning power of the m(+1)φ(t+1)=I(4) firms assets and its investment policy IX(E)-D(/. (4) and not by how the fruits of the earning power are "packaged"for distribution Substituting expression(4)into(3), the, Obvious as the proposition may be, D( cancel and we obtain for the value however, one finds few references to it in of the firm as of the start of t the extensive literature on the problem.' It is true that the literature abounds with V()≡()夕(4) statements that in some <theoretical 1+p(IX(O-I(0+V\+/ C 5)sense, dividend policy ought not to count; but either that sense is not clearly specified or, more frequently and espe D (does not appear directly cially among eco onomists, it is(wrongly) the arguments and since X o, identified with a situation in which the r (t+ 1)and p(o are all independ- firm's internal rate of return is the same ent of D((either by their nature or by as the external or market rate of re ssumption) it follows that the current turn 2 value of the firm must be independent of A major source of these and related the current dividend decision misunderstandings of the role of the divi- Having established that V( is unaf- dend policy has been the fruitless concern fected by the current dividend decision and controversy over what investors it is easy to go on to show that v()must "really" capitalize when they buy shares also be unaffected by any future dividend We say fruitless because as we shall now decisions as well. Such future decisions proceed to show, it is actually possible to can influence V(O)only via their effect on derive from the basic principle of valua V(t+1). But we can repeat the reason- tion(1) not merely one, but several valu- ing above and show that V(t+ 1-and ation formulas each starting from one of hence V(O-is unaffected by dividend the "classical"views of what is being policy in t+1; that V(+ 2)-and capitalized by investors. Though differ- hence V(t+ 1)and v(t-is unaffected ing somewhat in outward appearance, by dividend policy in t+ 2; and so on the various formulas can be shown to be for as far into the future as we care to equivalent in all essential respects in look. Thus, we may conclude that given a cluding, of course, their implication that firm's investment policy, the dividend dividend policy is irrelevant. While the payout policy it chooses to follow will af 1 Apart from the references to it in our earlie fect neither the current price of its shares papers, especially [161, the closest nor the total return to its shareholders seems to be that in Bodenborn [1 Like many other propositions in ec his treatment of the role of divi policy is not nomics, the irrelevance of dividend pol mpletely explicit. (The numbers in brackets refer references listed below, pp. 432-33 icy, given investment policy,is“obⅵious, See below p 424 his content downloaded from 202.. 18.13 on Wed, 1 1 Sep 2013 02: 04: 42 AM All use subject to JSTOR Terms and Conditions414 THE JOURNAL OF BUSINESS indeed be the case. Specifically, if I(t) is the given level of the firm's invest￾ment or increase in its holding of physical assets in t and if X(t) is the firm's total net profit for the period, we know that the amount of outside capital required will be m(t+1)p(t+1) = I(t) (4) - [X (t) -D (t) ]. Substituting expression (4) into (3), the D(t) cancel and we obtain for the value of the firm as of the start of t V (t)-n (t) p (t) (5) = +p(t)[X 1 (t)-I(t) + V(t+ 1) Since D(t) does not appear directly among the arguments and since X(t), I(t), V(t + 1) and p(t) are all independ￾ent of D(t) (either by their nature or by assumption) it follows that the current value of the firm must be independent of the current dividend decision. Having established that V(t) is unaf￾fected by the current dividend decision it is easy to go on to show that V(t) must also be unaffected by any future dividend decisions as well. Such future decisions can influence V(t) only via their effect on V (t + 1). But we can repeat the reason￾ing above and show that V(t + 1)-and hence V(t)-is unaffected by dividend policy in t + 1; that V(t + 2)-and hence V(t + 1) and V(t)-is unaffected by dividend policy in t + 2; and so on for as far into the future as we care to look. Thus, we may conclude that given a firm's investment policy, the dividend payout policy it chooses to follow will af￾fect neither the current price of its shares nor the total return to its shareholders. Like many other propositions in eco￾nomics, the irrelevance of dividend pol￾icy, given investment policy, is "obvious, once you think of it." It is, after all, merely one more instance of the general principle that there are no "financial il￾lusions" in a rational and perfect econom￾ic environment. Values there are deter￾mined solely by "real" considerations￾in this case the earning power of the firm's assets and its investment policy￾and not by how the fruits of the earning power are "packaged" for distribution. Obvious as the proposition may be, however, one finds few references to it in the extensive literature on the problem.' It is true that the literature abounds with statements that in some "theoretical" sense, dividend policy ought not to count; but either that sense is not clearly specified or, more frequently and espe￾cially among economists, it is (wrongly) identified with a situation in which the firm's internal rate of return is the same as the external or market rate of re￾turn.2 A major source of these and related misunderstandings of the role of the divi￾dend policy has been the fruitless concern and controversy over what investors "really" capitalize when they buy shares. We say fruitless because as we shall now proceed to show, it is actually possible to derive from the basic principle of valua￾tion (1) not merely one, but several valu￾ation formulas each starting from one of the "classical" views of what is being capitalized by investors. Though differ￾ing somewhat in outward appearance, the various formulas can be shown to be equivalent in all- essential respects in￾cluding, of course, their implication that dividend policy is irrelevant. While the 1 Apart from the references to it in our earlier papers, especially [16], the closest approximation seems to be that in Bodenborn [1, p. 4921, but even his treatment of the role of dividend policy is not completely explicit. (The numbers in brackets refer to references listed below, pp. 432-33). 2 See below p. 424. This content downloaded from 202.115.118.13 on Wed, 11 Sep 2013 02:04:42 AM All use subject to JSTOR Terms and Conditions