Is hyperbolic discounting the missing piece in the dividend puzzle?

Abstract

Purpose The purpose of this paper is to explain how and why exponential discounting became a taken-for-granted assumption in Miller and Modigliani’s dividend irrelevance theory and to determine what that inheritance cost the theory by testing whether dividend irrelevance survives once the assumption is replaced.

Design/methodology/approach The paper combines the history of economic thought with financial mathematics. It reconstructs the intellectual and institutional setting in which the dividend irrelevance theory was produced, marked by the axiomatization of rational choice and the postwar reform of American business education. It then compares the initial outlay required to replicate a given stream of future payments in a dividend-paying and a non-dividend-paying firm, under exponential and hyperbolic discounting.

Findings The dividend irrelevance theory holds under exponential discounting and fails under hyperbolic discounting, with the valuation gap between a dividend-paying and a non-dividend-paying company persisting regardless of how profitable the latter’s reinvestment policy is. The assumption postwar finance inherited without examination was therefore substantive, not merely technical.

Originality/value Previous literature has challenged dividend irrelevance by relaxing one or more of Miller and Modigliani’s market assumptions while implicitly retaining exponential discounting as the only coherent intertemporal preference structure. This paper shows that the omission was the product of a paradigm in which dynamic consistency had been redefined into a criterion of rationality and that the theory fails once the discounting assumption is replaced with the market assumptions left intact.