Miller and Modigliani theory on Dividend Policy

Definition: According to Miller and Modigliani Hypothesis or MM Approach, dividend policy has no effect on the price of the shares of the firm and believes that it is the investment policy that increases the firm’s share value.

The investors are satisfied with the firm’s retained earnings as long as the returns are more than the equity capitalization rate “Ke”. What is an equity capitalization rate? The rate at which the earnings, dividends or cash flows are converted into equity or value of the firm. If the returns are less than “Ke” then, the shareholders would like to receive the earnings in the form of dividends.

Miller and Modigliani have given the proof of their argument, that dividends have no effect on the firm’s share price, in the form of a set of equations, which are explained in the content below:

Proof of Miller and Modigliani Hypothesis

Assumptions of Miller and Modigliani Hypothesis

1. There is a perfect capital market, i.e. investors are rational and have access to all the information free of cost. There are no floatation or transaction costs, no investor is large enough to influence the market price, and the securities are infinitely divisible.
2. There are no taxes. Both the dividends and the capital gains are taxed at the similar rate.
3. It is assumed that a company follows a constant investment policy. This implies that there is no change in the business risk position and the rate of return on the investments in new projects.
4. There is no uncertainty about the future profits, all the investors are certain about the future investments, dividends and the profits of the firm, as there is no risk involved.

Criticism of Miller and Modigliani Hypothesis

1. It is assumed that a perfect capital market exists, which implies no taxes, no flotation, and the transaction costs are there, but, however, these are untenable in the real life situations.
2. The Floatation cost is incurred when the capital is raised from the market and thus cannot be ignored since the underwriting commission, brokerage and other costs have to be paid.
3. The transaction cost is incurred when the investors sell their securities. It is believed that in case no dividends are paid; the investors can sell their securities to realize cash. But however, there is a cost involved in making the sale of securities, i.e. the investors in the desire of current income has to sell a higher number of shares.
4. There are taxes imposed on the dividend and the capital gains. However, the tax paid on the dividend is high as compared to the tax paid on capital gains. The tax on capital gains is a deferred tax, paid only when the shares are sold.
5. The assumption of certain future profits is uncertain. The future is full of uncertainties, and the dividend policy does get affected by the economic conditions.

Thus, the MM Approach posits that the shareholders are indifferent between the dividends and the capital gains, i.e., the increased value of capital assets.