Optimal Cap Structure

What theories do you know about dividend payments and value of the company?

1) Modigliani and Miller (MM)

Modigliani – Miller theory is a major proponent of ‘Dividend Irrelevance’ notion. According to this concept, investors do not pay any importance to the dividend history of a company and thus, dividends are irrelevant in calculating the valuation of a company. This theory is in direct contrast to the ‘Dividend Relevance’ theory which deems dividends to be important in the valuation of a company.

Miller-Modigliani theorem – argues that the value of a firm is independent of its capital

structure. In other words, changing your financing mix should have no effect on your firm

value.

Assumptions of the Model

Modigliani – Miller theory is based on the following assumptions:

* Perfect Capital Markets: This theory believes in the existence of ‘perfect capital markets’. It assumes that all the investors are rational, they have access to free information, there are no floatation or transaction costs and no large investor to influence the market price of the share.

* No Taxes: There is no existence of taxes. Alternatively, both dividends and capital gains are taxed at the same rate.

* Fixed Investment Policy: The company does not change its existing investment policy. This means that new investments that are financed through retained earnings do not change the risk and the rate of required return of the firm.

* No Risk of Uncertainty: All the investors are certain about the future market prices and the dividends. This means that the same discount rate is applicable for all types of stocks in all time periods.

Valuation Formula and its Denotations

Modigliani – Miller’s valuation model is based on the assumption of same discount rate / rate of return applicable to all the stocks.

P1 = P0 * (1 + k) – D

Where,

P1 = market price of the share at the end of a period

P0 = market price of the share at the beginning of a period

k = cost of capital...