Question

Assume that a company in the early stages of growth has financed itself using only a very small percentage of debt in its capital structure. It pays no dividends to its shareholders. Modigliani and Miller might well have made the following statement regarding dividend policy: "(like capital structure) the dividend policy decision of company will not affect its valuation". Explain what is meant by this statement and under what conditions it will be true. Then explain why it might not hold in reality

Answer 1

The Modigliani and Miller approach says the declaration of dividend will not effect the market price of the firm. in other words they argue that , whether the dividends are paid or not it will not effect the market price of the share.

This theory gives few assumptions only under which it will come to true.

1. Perfect market - Companies operate in a perfect capital market. And a perfect market gives the following assumptions.

   a) There are a large number of buyers and sellers. No individual buyer or seller can alter market prices

   b) The investors are behave rationally.

   c) There is a free flow of information. No investor is privileged to get price sensitive informatio.

2. This theory assumes there is no corporate tax or personal tax

3. There is no risk of uncertainity

4. There is no external funds. All are from either equity or retained earnings.

5. There is fixed investment policy. Which means in each year end the company invests a specific amound as capital expenditure

We will consider the following situations..

Situation 1. Company have suffient cash pay dividends.

In this situation if the company pay dividend its cash balance get reduced and what share holder gain in th form of cash is nothing but they lose in the form of reduced assets (cash) in the comapny. Thus the value of the firm remains unaffected.

Situation 2. Company does not have cash to pay dividend.

In this situation company will issue new shares. If its a right issue the share holder gives cash and recieves its back in the form of Dividends. If its a public issue the existing shareholders transfers a part of their claim in the form of shares and recieves cash. There is no gain or loss, the value is uneffected.

So its proven by this theory that dividend is not MATTER!

Why it might not be in Reality.

Because of the flawed assumptions this theory is criticised. The assumptions like perfect market and zero taxes are divorced from reality.

Moreover the informational content of dividend , agency cost cuts, presence of issue costs and transactions costs confirm that dividends are relevant and might change the market value.