Discuss the main contribution of Modigliani and Miller to financial theory (At least 400 words）.

Expert Answer

The Modigliani-Miller (M&M) theorems, developed by economists Franco Modigliani (1918–2003) and
Merton Miller (1923–2000) in a series of papers, represent a major milestone in corporate finance
theory. Modigliani and Miller won Nobel prizes in economics in 1985 and 1990, respectively, in part for
their contributions to what are often referred to as the capital structure irrelevance and dividend
irrelevance theorems.

Contrary to financial theory of the time, which focused on institutions, the M&M theorems were among
the first efforts by economists to bring rigorous analysis to the understanding of corporate finance
issues. Corporate financial capital, the funds invested in a firm, consists of money borrowed from others
(bonds and loans) and business owners' own money (stock). Lenders receive a stated rate of interest
and have the first claim on corporate assets. Stockholders receive all remaining current and future
profits of the company. Leverage represents the proportion of debt (bonds and loans) to stock.
Modigliani and Miller (1958) presented the idea that, assuming perfect financial markets and in the
absence of taxes, the value of a levered firm is the same as that of an unlevered firm if both firms
represent the same investment opportunities. In other words, change in capital structure (the mixture of
debt and stock) alone does not affect a firm's value. Their no-arbitrage proof stated that, if these firms
have different values, investors will be able to replicate the higher-valued firm with the lower-valued
firm plus their own borrowing or lending. Alternatively, management of the firm can change the capital
structure of the firm to achieve its highest value. In a later paper, Modigliani and Miller argued that a
firm's value is not affected by its dividend policy (payment to stockholders) because increased return in
the form of dividends is offset by the reduction in the firm's assets.

The M&M framework and methodology had a major impact in shaping future research. In the decades
that followed, the corporate finance literature was significantly enriched by attempts to relax various
original M&M assumptions, such as no taxation and no bankruptcy costs. The no-arbitrage proof has
also become part of financial economists' standard toolkit and was applied in many prominent works,
such as the development of the put-call parity in option pricing theory.

Introducing corporate income tax into the model leads to the naive result that the firm should depend
on debt financing alone to maximize the benefit of the tax shield. The reason that this is not observed in
the business world is because the tax benefit for debt financing at the firm level is counterbalanced by
unfavorable tax treatment at the household level. Dividends and bond returns are taxed annually, while
taxes on unrealized equity returns can be indefinitely deferred. In most jurisdictions, corporations and
households are subject to different tax rates. The risk of bankruptcy also limits the amount of debt a
firm should use, since the cost of equity increases with leverage. Consequently, different tax situations
and risk preferences demand firms with different kinds of capital structures. The fact that firms choose
different tax structures attests to the validity of the capital structure irrelevance theorem, rather than
discrediting it.

Relaxing the assumption that managers and shareholders have the same information about a firm's cash
flow, researchers developed the signaling theory of dividends. Because managers tend to have
information not yet available to shareholders, their action to increase or decrease dividends often
reflects information not yet embedded in the stock price. This extension of the M&M theorems explains
why stock prices often react to changes in dividends.

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Question:

Discuss MM (Modigliani, Miller) model on dividend policy and and its practical limitations.

(500 words explanation needed)

Expert Answer

According to M&M theory [modigliani & Miller theory) states that dividend policy is irrelevant and
declaration of dividend does not change or affect the market value of the firm infact it is the investment
policy which determines and affects the value of the firm because value of the firm depends upon
earnings and earnings in turn depends upon on firms investment policy. they have proved this by way of
an equation. Where p0 = current market price, n=present no of shares , m=additional shares issued at
year end at year end price to finance capital expenditure, p1=year end market price, I1=investment
made at year end with money being raised at year end MP, X1=earnings in year1, ke=cost of equity. i)
the current market price at the end of the period is equal to pv of dividends received +market price at
year end I.e.,P0=D1+P1/(1+ke). ii)assumed that no external capital is raised so the total capitalized value
of the firm is the number of shares times the price of the share P0. P0=[n(D1+P1)/(1+ke)]
=[nD1+nP1]/(1+ke). iii)if retained earnings are not sufficient to finance new project,additional shares are
issued at year end at P1 price. nP0=(nD1+nP1+mP1-mp1)/(1+ke)=[nD1+nP1(n+m)-mP1]/(1+ke). iv) but
mP1 which is the total issue in t1 is equal to total investment in t1 less retained earnings therefore we
get =[nD1+nP1(n+m)-(I1-(X-nD1))]/(1+ke). v)simplifying the above we get [(n+m)P1-I1+X1]/(1+ke) so we
dont have D1 I.e., dividends in the final formula it is proved that dividend declaration does not affect the
value of the firm. Assumptions of M&M theory a)existence of perfect capital markets. b)fixed
investment policy. c)no tax. d)no risk of uncertainty. e)no external funds. Following are the limitation of
the theory 1) the assumption of perfect market is not practical, in real world various imperfections exists
such as differential rates of interest,transaction costs for purchase and sale of securities etc. 2)the
argument that arbitrage nullifies the effect of leverage is not valid.investors do not behave in such a
calculated and rational way in switching from leveraged to unlevered firm or vice versa. 3)theory
assumes available of free and upto date information on all aspects of functioning of the company, in
practice investors have little or no knowledge about company operations.their dealings in shares are
based not only upon the information on hand but on other factors as well.