What is Miller and Modigliani theory on Dividend Policy?...

Question

Modigliani- Miller Theory on Dividend Policy

Answer 1

Miller and Modigliani in 1961 argued that in a perfect market, the value of a firm remains unaffected by its dividend policy. The most famous M&M proposition of irrelevance says that value of firm is not affected by changes in dividend policies. This MM theory is based on the various following assumptions: -

The basic M&M proposition is based on the following key assumptions:

1) No tax in the perfect market.

2) No transaction cost.

3) Equivalent borrowing cost for both company and investors.

4) Companies and investors have the same information

5) No effect of debt on a company's earnings before interest and taxes

However, in realty corporate values are affected by changes in capital structure and dividend. Their theory suffers from the following limitations: -

1) In the real world, perfect markets do not exist.

2) Taxes are present in the market.

3) The assumption of no uncertainty is not correct. There will be uncertainty in the market and shareholders.

4) Shareholders wealth is affected by dividends because they have transaction costs associated with them.

So, in summary, this may be the most famous proposition by MM, it does suffer with many limitations and may not be suitable in the real market.