Miller and Modigliani - Essay Example

The higher the company is able to retain earnings, the lesser the dividends and the lower the retention, the larger the dividends. Finance managers then need to make a wise decision on dividends payments and investment fuelling funds from the net profit of the firm. Since the overall goal of doing business is profit maximization, organizations must know which of the two practices is better in terms of wealth creation. If it will not lead to wealth creation for the shareholders, the funds should be retained to support investment programmes.

A conflict therefore arises on whether dividends payment impacts the value of the organization or not. Some critics argue that dividends are irrelevant in that the percentage paid to the shareholders does not impact the value of the business while others maintain that dividends are relevant as far as the value of the organization is concerned (Baker,2009). Modigliani and Miller Hypothesis (MM Hypothesis) Both are on the idea that dividends are irrelevant in that they have no effect on the organization’s value and do not have serious repercussions on the firm.

According to them, choosing an investment programme that will contribute to the firm’s profit is what is important in adding value to the business. The process of dividends sharing is less important. In the event of good markets, realistic investments, and proper tax allocation between dividend revenue and business capital, provided the organization’s investment programme, dividend sharing has no effect on the market price of shares. Their theory on irrelevance of dividends is grounded on the following assumptions; First is that the business is conducted in an environment of perfect capital markets characterized by availability of sufficient and free information at all times, no or less exchange expenses and realistic investments.

The investors are not a threat to the market price of goods and services. Also the investors are assumed to be realistic, implying that the main and only goal of shareholders is wealth maximization without discriminations on dividends sharing. They need to be satisfied with the amount that they get from the shares. Modigliani and Miller assumed that tax is ‘non-existent’. Therefore there should be no tax disparities such that the tax levied on dividend is not the same with that of the earnings.

If there is tax, it should be equal. The idea is to provide a differentiation between revenue from dividends and from capital earnings. Again, the investment programmes of the organization are assumed to be consistent, i.e. they do not change constantly. The investors most also be in a position to make an intelligent guess about future investment programmes and how much profit they will generate (Frankfurter, wood & wansley, 2003). The argument’s bone of contention is that provided the firm’s investment decision, it can keep its revenue for financing investment programmes or distribute the profit to the shareholders.

The market share increases from the payment of dividends while other added shares pose a drop in the value of shares. This means that the market price does not change with dividends payment. The external business support is said to affect the dividend payment on the wealth of shareholders which makes them indifferent in deciding between dividends and keeping the firm’s revenue to channel investment programmes. In this view, the business external support that is said to affect dividends payment fails to capture mm’s hypothesis of dividends irrelevance.

If dividends were irrelevant, the organization’s capital expenses would rely on their rate of dividend distribution (Banarjee, 1990). The assumption on perfect capital m