Modigliani and Miller Irrelevance Theory

Group Assignment 

a) Modigliani and Miller irrelevance Theory

Modigliani and Miller argued that dividends do not affect the wealth of shareholders thus dividends are irrelevent to shareholders wealth. They put forward the following assumptions;

-Capital markets are perfect; investors are rational information is freely availble, transaction costs are nil. Securities are divisible and no investor can influence the market price of the share.

-There is a given investment policy-the firm has a fixed investment policy which will not change. So if the retained earningsare reinvested there will not be any change in the risk of the firm.

-Floatation costs does not exist

-There are no taxes thus no difference between tax rates on dividends and capital gains

This is known as the "dividend-irrelevance theory", indicating that there is no effect from dividends on a company's capital structure or stock price.                

b) Bird in hand Theory .

This is alternatively called Dividend Relevance Theory by Myron Gordon and John Lintner. They argued that investors prefer current dividends as they can reinvest money in the market.

Assumptions;

-Investors are risk averse- investors are ratioonal and they want to avoid risk

-They put a premium on a certain return and discount (pernalise ) uncertain return.

The term risk refers to the possibility of getting return on investment. Therefore the payment of dividends removes any chance of return on investment but if the firm retains earnings, investors can expect to get dividends in the future. However, future dividend is uncertain both with the respect to the amount as well as the timing. Rational investors, therfore, prefer current dividends than those in future.The bird-in-the-hand may sound familiar as it is taken from an old saying: "a bird in the hand is worth two in the bush." In this theory "the bird in the hand' is referring to dividends and "the bush" is referring to capital

c) Any other two dividend policy theories

Tax-Preference theory                                                                                                                          Taxes are important considerations for investors. Remember capital gains are taxed at a lower rate than dividends. As such, investors may prefer capital gains to dividends. Additionally, capital gains are not paid until an investment is actually sold. Investors can control when capital gains are realized, but, they can't control dividend payments, over which the related company has control.  

The tax preference theory states that some investors prefer long-term capital gains to current dividend yield and will pay more for the stock of a firm that plows back its earnings into capital-appreciating projects instead of paying these earnings out as dividends. Taxes (and the time value of money) are the basis of this preference since stock price appreciation is taxed more favorably than dividend income. 

The residual theory of dividends

The theory suggests that the dividend paid by a firm should be viewed as a residual – the amount left over after all acceptable investment opportunities have been undertaken. This means dividends can only be paidafter the company has investedin all projects that offer a return greater or equal totheuir required rate of return.