Contrary to Miller and Modigliani [1961. Dividend policy, growth, and the valuation of shares. Journal of Business 34, 411–433], payout policy is not irrelevant and investment policy is not the sole determinant of value, even in frictionless markets. MM ask “Do companies with generous distribution policies consistently sell at a premium above those with niggardly payouts?” But MM's analysis does not address this question because the joint effect of their assumptions is to mandate 100% free cash flow payout in every period, thereby rendering “niggardly payouts” infeasible and forcing distributions to a global optimum. Irrelevance obtains, but in an economically vacuous sense because the firm's opportunity set is artificially constrained to payout policies that fully distribute free cash flow. When MM's assumptions are relaxed to allow retention, payout policy matters in exactly the same sense that investment policy does. Moreover (i) the standard Fisherian model is empirically refutable, predicting that firms will make large payouts in present value terms, (ii) only when payout policy is optimized will the present value of distributions equal the PV of project cash flows, (iii) the NPV rule for investments is not sufficient to ensure value maximization, rather an analogous rule for payout policy is also necessary, and (iv) Black's [1976. The dividend puzzle. Journal of Portfolio Management 2, 5–8] “dividend puzzle” is a non-puzzle because it is rooted in the mistaken idea that MM's irrelevance theorem applies to payout/retention decisions, which it does not.

Consistent with a life-cycle theory of dividends, the fraction of publicly traded industrial firms that pay dividends is high when retained earnings are a large portion of total equity (and of total assets) and falls to near zero when most equity is contributed rather than earned. We observe a highly significant relation between the decision to pay dividends and the earned/contributed capital mix, controlling for profitability, growth, firm size, total equity, cash balances, and dividend history, a relation that also holds for dividend initiations and omissions. In our regressions, the mix of earned/contributed capital has a quantitatively greater impact than measures of profitability and growth opportunities. We document a massive increase in firms with negative retained earnings (from 11.8% of industrials in 1978 to 50.2% in 2002). Controlling for the earned/contributed capital mix, firms with negative retained earnings show virtually no change in their propensity to pay dividends from the mid-1970s to 2002, while those whose earned equity makes them reasonable candidates to pay dividends have a propensity reduction that is twice the overall reduction in Fama and French [2000, Journal of Financial Economics 76, 549–582]. Finally, our simulations show that, if well-established firms had not paid dividends, their cash balances would be enormous and their long-term debt trivial, thus granting extreme discretion to managers of these mature firms.