Pros And Cons Of Modigliani-Miller Theory

The dividend policy has grown over the years. This may be so that the company projects itself as a less risky share and thus also gaining investors faith. The investors buy its shares and thus increase its demand. This helps to gives positive signals to the investors signalling that the company is stable and can generate earnings steadily. This hypothesis is gains standing from the dividend hypothesis theory.

It is believed that Efficient Market Theory is based upon some fallacies and it does not provide strong grounds of whatever that it proposes. More importantly the Efficient Market theory is perceived to be too subjective in its definition and details and because of this it is close to impossible to accommodate this theory into a meaningful and explicit financial model that can actually assist investors in making the investment decisions (Andresso-O’Callaghan, B., 2007).

Retained earnings will deprive the shareholder’s opportunity to reinvest the dividends in stock or bonds. So the shareholders are given the same amount as they would have received as retained earnings through dividends and so in such case the company incurs a cost for retaining the earnings.

When a company decides to pay dividends, it has to be careful on how much it will be given to the shareholders. It is of no use to pay shareholders dividends

Retained Earnings Statement shows amounts and causes of changes in retained earnings during the period. Time period is the same as that covered by the income statement. Users can evaluate dividend payment practices. This statement shows the changes in the shareholders’ equity account. The first line item is the beginning balance for common stock. The amount of newly issued common stock is added to the

Retained earnings represent the amount a company has left after it has paid all its expenses, taxes, and dividends. A company can return all the cash it has left after it has taken care of its obligations, but that would handicap its efforts to expand operations, make

Dividends are payments made by a company to its shareholders during a specified time intervals, say, quarterly or yearly. It is the portion of corporate profits paid out to stockholders. When a company earns money out of the business, that money can be put to two uses: it can either be re-invested in the business or it can be paid to the shareholders. This payment is called dividend.

Since the emergence of the so-called irrelevance theorem by Miller and Modigliani (1961), many corporations are puzzled about why some firms pay dividends while others do not. They were the first to study the effect of dividend policy on the market value of firms by assuming that there are no market imperfections. Miller and Modigliani (1961) proposed that divided policy chosen by a firm has no significant relationship in as far as the market valuation of the firm is concerned. They went further to explain that; the shareholders wealth remains unchanged irrespective of how the firm distributes it income because the firms’ value is rather determined by their investment policies and the earning power of its assets. They further stated that the opportunity to earn abnormal returns in the market does not exist, that is, owners are entitled to the normal market returns adjusted for risk.

Dividend Policy | -Pay out dividend to shareholders in profitable period | -100% plowback to reinvest in the business |

In practice, dividend policy will be affected by taxes as tax rates for different categories of investors will differ. Also, a firm’s dividend policy is perceived by the financial markets to be a signaling mechanism. A cut back in dividends may signify that the firm perceives tough

The fact that shareholders are taxed twice through this repayment methodology infers that dividends are not their repayment technique of choice. Furthermore, paying out cash reserves through dividends also has the effect of both reducing the company’s assets and also inhibited the company’s ability to fund future growth as Dividends reduce the company’s retained earnings.

Dividends are subjected to higher tax rate compare to capital gain increased due to share buy-back. This discourages shareholders from desire to receive high dividends in place of higher capital gain as share values increase. A comparison is made below between the proposed capital structure and dividend policy.

Retained earnings are profits generated by a company that are not distributed to shareholders as dividends but are either reinvested into the business or kept as a reserve for specific objectives these being to pay off debt or purchase a capital asset. As you can see in Humbros statement of financial position under capital and reserves they have retained earnings at 9,100 in 2011 and 10,500 in year 2012 this has shown an increase which means there is more capital available for growth and higher returns on investments and shareholder equity.

There are many theoretical and empirical results describing the decisions companies make in this area. At the same time, however, there is no generally accepted model describing payout policy. Moreover, empirical findings are often contradictory or difficult to interpret in light of the theory. In their seminal paper, Miller and Modigliani (1961) showed that under certain assumptions dividends are irrelevant; all that matters is the firm’s investment opportunities. Miller and Modigliani considered the case of perfect capital markets (no transaction costs or tax differentials, no pricing power for any of the participants, no information asymmetries or costs), rational behaviour (more wealth being preferred to less, indifference between cash payments and share value increases) and perfect certainty (future investments and profits are given). In real life, however, people seem to care about dividends. Lintner.s (1956) classical study on dividend policy suggests that dividends represent the primary and active decision variable in most situations. Lintner suggests a model of partial adjustment to a given payout rate.

The first objection is related to the fact that this is a totally new approach concerning dividend policy, and nobody can predict what is going to happen. We consider that this may have positive effects on share prices, especially taking in consideration that it will stabilise the market price of the company.