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Corporate Finance Issues - Essay Example

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Corporate Finance Issues

In their classic papers on these issues, Miller and Modigliani (1958 and 1961) used as a starting point that the company has settled on its investment programme and determined how much of the investments would be financed from debt, with the remaining funds required being funded from retained earnings, and any surplus funds would be paid out as dividends. If the company decides to increase dividends without changing the investment and borrowing policy, the funds that would be needed to pay the dividends should come from somewhere. If debt is fixed, the only way it can fund extra dividends is to sell more shares. The new stockholders would invest only if you offer them shares worth as much as they cost, but how can the firm do this when its assets, earnings, investment opportunities, and therefore, market value are all unchanged
The answer is that there must be a transfer of value from the old to the new stockholders, with the new ones getting the new shares, each one worth less than before the dividend change was announced, and the old ones suffering a capital loss on their shares. The capital loss of the old shareholders would just offset the extra cash dividend they receive. Would it matter to the old stockholders to receive extra dividends plus an offsetting capital loss It would if that were the only way they can get cash. But as long as there are efficient capital markets, they can raise the cash by selling shares. Thus, the old shareholders can "cash in" either by persuading management to pay a higher dividend or by selling some of their shares. In either case, there will be a transfer of value from old to new shareholders, and the only difference is that in the former case (higher dividends) this transfer is caused by a dilution in the value of each of the firm's shares, and in the latter (selling their shares) it is caused by a reduction in the number of shares held by the old shareholders.
Miller and Modigliani then conclude that because investors do not need dividends to get their hands on cash (because they can sell shares to do so), they will not pay higher prices for the shares of firms with high payouts. Therefore, firms should not worry about dividend policy and should just let dividends fluctuate as a by-product of their investment and financing decisions. ...Show more

Summary

The notion that capital structure affects the value of a listed company proceeds from the thinking that debt, which is more risky, is not as good as equity. After all, when a company fails to pay its debts, creditors can get the company's assets and sell them off as payment, whilst if a debt-free company goes bankrupt, the investors at least get the assets…
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Corporate Finance Issues essay example
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