M & M Dividend Policy Theory

Dividend policy is a group of guild lines that are set out for a company to follow in order to calculate their earnings which need to be paid out to their shareholders. Dividends is a percentage of the company’s earnings that are paid to the company’s shareholders which is decided by the board of directors.

There are two ways that a financial manager can handle their dividend decisions. The first way will be a long-term financing, which means when a dividend is handled as the source of a company’s finance. Also, the company can pay their dividends and raise an equal number of shares sold to shareholders. The second way that a financial manager handles the company’s dividends will be to use wealth maximisation, which means that the dividend

The distribution of dividends should have little to no impact on the stock price. An example of the irrelevant model would be Modigliani and Miller.

Modigliani and Miller (M&M) 1950s

Irrelevant theory

“The M&M theory suggests that it would be a perfect world without taxes or bankruptcy.”

M&M’s theory believes that the dividend policy is irrelevant to the company’s market value and that a dividend payment should have no effect on the stock price or capital structure. The valuation of a company has no effect on its capital structure, it has no impact on its market value and the market value is decided on the operation profits within the company.

If a dividend is more than what the company expected it to be, then the company can reinvest in the it’s stocks which has a surplus cash flow in order to balance their dividend payments to which they thought matched their expected payment.

If a dividend is smaller than what the company expected, then the company may sell part of their shares in order to replicate the expected dividend payments that need to be paid

Another disadvantage is that their capital market is expected to be constantly perfect when this can change. Another disadvantage is that there is full pay outs, meaning that the net earnings that are paid out to their shareholders are needed to be paid out in full. Lastly the risk of estimates, meaning that when estimating the earnings to be paid out may end up fluctuating or not turning out as what the investors expected.

M&M’s model is based on confident assumptions.

This model’s assumptions are that, the capital markets are perfect, meaning that no investor can influence the market value of a company’s shares. That there is no difference between the tax rates on the dividend payments and capital gains. The company has a fixed investment policy which will have no charge, meaning that the retained earnings are reinvested. This model also believes that there is no floatation.

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