Question

[Ch 14] 8. It has been shown that in the absence of taxes and other market imperfections, firm value will be naffected by dividend policy. Explain the logic behind this conclusion. Next, describe three real-world factors that may cause one dividend policy to be preferable to another. I 9 The residual dividend approach is the best dividend policy to adopt if a firm's management wants to maximize the current value per share of the existing stock. Do you agree or disagree with this statement? State and justify your conclusions

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Answer 1

8) Modigliani and Miller propounded the theory of irrelevance which states that in the absence of taxes and other market imperfections, the dividend policy is irrelevant. They suggested that dividend policy won't affect the market value of the firm i.e. it share price. MM highlights that investors will adjust the expected dividend with the capital gain on the stock. They will buy the shares by re-investing the surplus dividend and sell the shares for the required cash flow if actual dividend is less than the expected dividend. Investors create their own cash flow. Thus whatever will be the dividend policy, it is irrelevant to the firm's value.

Three real world factors that may cause one dividend policy to be preferable to another are:

1. Stability of the company's income: Companies with the stable income pay higher dividends than the volatile income company.

2.Better alternative to dividend payoff: Company choose to not to pay the dividends in spite of the stability of income as it has better use of profits to reinvest in business.

3. Tax considerations: As dividend are highly taxed, therefore company may choose not to pay the dividend and can find another alternative to return the capital gain like repurchase of shares.

9) In the Residual dividend policy, company pay out dividend from the earnings that is remained after paying the capital expenditures or working capital. Though it is highly volatile, but the most preferable one as investors are assured that the company has paid it's debt and there is no increased debt with the need to pay dividends. Thus, this policy help to maximize the firm's value.