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Finance & Accounting
Pages 6 (1506 words)
Name: Course: Professor: Date: Q1. The Modigliani and Miller paper mentions that a firm’s value is never affected by how it is financed, may it be through bankruptcy, absence of taxes or agency costs. This Modigliani-Miller theorem is also known as the principle of capital structure irrelevance.
They also state that the market value is not determined by the dividend policy. In relation to the irrelevance of dividends, two theorems are applied; these are Modigliani-Miller approach and residual theory (Thompson & Mathew 82). Q2. The major assumption behind the residual income valuation model is the clean surplus relationship, that stresses the relationship among book value per share, dividends and earnings: BV1 = BV0 + EPS1 - D1. It means that all the accounting profits and distribution to shareholders can be explained by changes in the book value. Another assumption is that the ohslon model comes from the information dynamics that brings together current information to future residual income. Consistent with Ohlson’s information dynamics it is found out that residual empirical research income follows a mean reverting process. In conclusion Ohlson’s formulation of the residual income valuation model provides an economical structure for incorporating information in earnings, book value and income forecasts. The fact that there are no taxes or difference in tax rates is another major assumption made. The book value of equity uses the clean surplus approach that states earnings and net dividends modify book equity. ...
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