Q.12
a. Explain why Modigliani and Miller argued that dividend policy should not affect the
valuation of a company’s shares. (500-word limit)
The Modigliani and Miller theory is suggesting the notion of Dividend Irrelevance. According to
the theorists, investors do not pay attention to the dividend history of a business, thus
factoring dividend value irrelevant when calculating the worth of a company. Overall
suggesting that the dividend policy of a company has no effect on the stock price of a business
nor its capital structure.
Modigliani and Miller state in their theory that if an investor receives a dividend which is
higher than expected, he/she can re-invest in the firm’s stock using the extra cash flow. If an
investor receives a dividend smaller than expected, he/she is more likely to sell part of the
shares to even out the loss, to recoup the same cash flow that would have been earned if the
dividend was as expected.
In general, investors are highly driven by bigger return rates, and are likely to generate that
return through reinvesting or selling a part of the shares to ensure that a cash balance or
surplus is obtained. If the market conditions are correct, it won’t matter if the return is earned
from dividends or from stock price appreciation.
An important aspect to consider when observing Modigliani and Miller’s theory, is the impact
of asset specific cash flows and risk. When a firm sets out to decide its capital budgeting and
asset value, dividend policy has no impact whatsoever.
For example, if a company with investment opportunities distributes its earnings between its
shareholders, it will have to raise capital required from outside, causing in an increase in the
number of shares, resulting in a fall in future earnings. Whatever a shareholder receives due to
an increased dividend will be neutralised completely because of the fall in value of shares,
since the expected earnings per share would decline.
b. Using the theories of signalling and clientele effects, explain why dividends may affect
company valuations. (500-word limit)
Dividend signalling is a notion which states how a company´s announcement of an increase in
dividend pay-out is regarded as an indicator for positive future earnings.
- Increasing a company´s dividend pay-out may predict favourable performance for the
company.
- The dividend signalling theory suggests that the businesses which pay the biggest
dividends, are more profitable than those paying smaller amounts.
- This concept indicates that the theory can be disrupted if a shareholder examines
extensively the current dividends as a forecast for future earnings.
- With signalling, there is asymmetry of information throughout the business, meaning
the managers and directors know more about the company and its prospects than the
investors do, this can result in problems if not managed properly, since the business
