Page 209 - DMGT409Basic Financial Management

Basic Financial Management

Notes Assumption

1. Capital markets are perfect: Investors are rational as information is freely available,
transaction cost are nil, securities are divisible and no investor can influence the market

price of the share.
2. There are no taxes: No difference between tax rates on divisible and capital gains.

3. The firm has a fixed investment policy: Which will not change. So if the retained earnings
are reinvested, there will not be any change in the risk of the firm. So K remains same.

4. Floatation costs does not exist:
The substance of MM arguments may be stated as below:
(a) If the company retains the earnings instead of giving it out as dividends, the share
holders enjoy capital appreciation, which is equal to the earnings, retained.
(b) If the company distributes the earnings by the way of dividends instead of retention,
the shareholders enjoy the dividend, which is equal to the amount by which his capital
would have been appreciated had the company chosen to retain the earnings.
Hence, the division of earnings between dividends and retained earnings is irrelevant from the
point of view of shareholders.

Criticisms

MM theory of division irrelevance is based on some assumptions. When these assumptions hold
good, the conclusions derived by them are logically consistent and intuitively appealing. But the
assumption will not hold water in the real world. So MM theory lacks practical relevance. The
following are some of the limitations.

1. Tax differentials: MM’s assumption that taxes does not exist is far from reality. Dividends
are not taxed where as tax is levied on capital gains. So the shareholders may prefer
dividend to capital gains.
2. Floatation cost: MM argue that payment of dividend and raising external funds are

equivalent. This is not true in practice due to the presence of flotation costs. So a rupee of
dividend cannot be replaced by a rupee by external funds. So it is advantageous to retain
the earnings.
3. Transaction costs: In the absence of transition cost a rupee of capital value can be converted
into a rupee of current income and vice versa. This implies that if the dividends are not
paid, the shareholders desiring current income can sell a part of their holdings without
incurring transaction cost. Because of the presence of the transaction cost, investors may
prefer current dividend than retained earnings.
4. Diversifi cation: If the company retains the earnings, investors cannot diversify their
portfolios. As the investors are willing to pay a higher value to the company which pays
more current dividend.

5. Uncertainty: MM argues that the prices of the 2 firms which are exactly identical in all the

respect except with the dividend policy cannot be different. But this is not true due to “bird
in hand argument”.

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