412 THE JOURNAL OF BUSINESS profits, and the rate of growth of divi- vestor as to the future investment pro- dends per share. Once these fundamen- gram and the future profits of every cor- tals have been established, we shall pro- poration. Because of this assurance ceed in Section IV to drop the assump- there is, among other things, no need tion of certainty and to see the extent to distinguish between stocks and bonds as which the earlier conclusions about divi sources of funds at this stage of the anal- dend policy must be modified. Finally, in ysis. We can, therefore, proceed as if Section V, we shall briefly examine the there were only a single type of financial implications for the dividend policy instrument which, for convenience, we problem of certain kinds of market im- shall refer to as shares of stock The fundamental principle of valua- lion.Under these assumptions the valu I. EFFECT OF DIVIDEND POLICY WITH PER- ation of all shares would be governed by FECT MARKETS, RATIONAL BEHAVIOR, the following fundamental principle: the AND PERFECT CERTAINTY price of each share must be such that the The meaning of the basic assumptions. rate of return(dividends plus capital S lthough the terms"perfect markets, gains per dollar invested)on every share rational behavior, and"perfect cer- will be the same throughout the market tainty"are widely used throughout eco- over any given interval of time. That is y spelling out the precise me. to start if we let nomic theory, it may be helpft of these assumptions in the present context d,0=dividends per share paid by firm j du capital markets, "no P:(0 ice(ex any dividend buyer or seller(or issuer)of securities is of a share in firmi at the start of large enough for his transactions to have orice. All traders have equal and costless we must have access to information about the ruling d, (2)+p:(+1)-pi (2) price and about all other relevant charac teristics of shares ( to be detailed spe- =p(t) independent of j cifically later). No brokerage fees, trans- fer taxes, or other transaction costs are or, equivalently, incurred when securities are bought sold,or issued, and there are no tax dif- p (0)-1+p(ld (0)+p; ( +1)1(2) ferential either between distributed and undistributed profits or between divi- for each i and for all t. Otherwise, holders dends and capital gains. of low-return(high-priced)shares could 2. " Rational behavior"means that increase their terminal wealth by selling investors always prefer more wealth to these shares and investing the proceeds less and are indifferent as to whether a in shares offering a higher rate of return given increment to their wealth takes the This process would tend to drive down form of cash payments or an increase in the prices of the low-return shares and the market value of their holdings of drive up the prices of high-return shares until the differential in rates of return 3.“ Perfect certainty olies com- had been eliminated plete assurance on the part of every in The effect of dividend policy. The im- his content downloaded from 202.. 18.13 on Wed, 1 1 Sep 2013 02: 04: 42 AM All use subject to JSTOR Terms and Conditions412 THE JOURNAL OF BUSINESS profits, and the rate of growth of divi￾dends per share. Once these fundamen￾tals have been established, we shall pro￾ceed in Section IV to drop the assump￾tion of certainty and to see the extent to which the earlier conclusions about divi￾dend policy must be modified. Finally, in Section V, we shall briefly examine the implications for the dividend policy problem of certain kinds of market im￾perfections. I. EFFECT OF DIVIDEND POLICY WITH PER￾FECT MARKETS, RATIONAL BEHAVIOR, AND PERFECT CERTAINTY The meaning of the basic assumptions. -Although the terms "perfect markets," "rational behavior," and "perfect cer￾tainty" are widely used throughout eco￾nomic theory, it may be helpful to start by spelling out the precise meaning of these assumptions in the present context. 1. In "perfect capital markets," no buyer or seller (or issuer) of securities is large enough for his transactions to have an appreciable impact on the then ruling price. All traders have equal and costless access to information about the ruling price and about all other relevant charac￾teristics of shares (to be detailed spe￾cifically later). No brokerage fees, trans￾fer taxes, or other transaction costs are incurred when securities are bought, sold, or issued, and there are no tax dif￾ferentials either between distributed and undistributed profits or between divi￾dends and capital gains. 2. "Rational behavior" means that investors always prefer more wealth to less and are indifferent as to whether a given increment to their wealth takes the form of cash payments or an increase in the market value of their holdings of shares. 3. "Perfect certainty" implies com￾plete assurance on the part of every in￾vestor as to the future investment pro￾gram and the future profits of every cor￾poration. Because of this assurance, there is, among other things, no need to distinguish between stocks and bonds as sources of funds at this stage of the anal￾ysis. We can, therefore, proceed as if there were only a single type of financial instrument which, for convenience, we shall refer to as shares of stock. The fundamental principle of valua￾tion.-Under'these assumptions the valu￾ation of all shares would be governed by the following fundamental principle: the price of each share must be such that the rate of return (dividends plus capital gains per dollar invested) on every share will be the same throughout the market over any given interval of time. That is, if we let dj(t) = dividends per share paid by firm j during period t pj(t) = the price (ex any dividend in t - 1) of a share in firm j at the start of period t, we must have dj(t) +pj(t+ 1) -pj(t) pj(t) ~~~(1) = p ( t ) independent of j; or, equivalently, pj( t)= [dj(t)+pj(t+)] (2) for each j and for all t. Otherwise, holders of low-return (high-priced) shares could increase their terminal wealth by selling these shares and investing the proceeds in shares offering a higher rate of return. This process would tend to drive down the prices of the low-return shares and drive up the prices of high-return shares until the differential in rates of return had been eliminated. The effect of dividend policy.-The im￾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