Question

What is operating, financial, and total leverage, and what is the relationship among them? What is the theory of capital structure suggested by Modigliani and Miller in 1958 for which they received Nobel Prize? Do you think this theory is still valid? Lastly, what is the residual theory of dividends and the key arguments with regard to dividend irrelevance and the relevance?

Answer 1

Operating Leverage : This helps in evaluating the change in operating income by changing the level of sales.

Financial leverage : is the amount of debt a company uses to finance the assets.

Total leverage: it an be calculated by multiplying the degree of operating and financial leverage. It measures the percentage change in earnings of shareholders for a percentage change in sales.

The degree of total leverage = operating leverage* financial leverage

The Modiglani Miller model states that the capital structure of a firm is irrelevant. Since, there is no benefits from debt, the capital structure is irrelevant . The capital structure does not influence a company's stock price, and the capital structure is therefore irrelevant to a company's stock price.

No, this theory is not valid. As debt has tax benefits associated with, introducing debt in the capital structure reduces the cost of capital.

Residual theory of dividends : residual – the amount left over after all acceptable investment opportunities have been undertaken. The first priority for a company using residual dividend policy is to use earnings to cash flow capital expenditures, and dividends are paid with any remaining earnings generated by the firm.

Dividend relevance theory states that the shareholders prefer current dividends. They prefer those firms which pay dividend.

Dividend irrelevance theory states that dividends are irrelevant. The MM dividend irrelevance theory states that the firm's dividend policy has no impact on firm value or its stock price. Dividend irrelevance theory states that dividends distributed as a residual are irrelevant.  Modigliani and Miller suggested that in a perfect world with no taxes or bankruptcy cost, the dividend policy is irrelevant.