Business Finance: Dividend Policy, Capital Structure, and Firm Value

This essay delves into the critical financing decisions of dividend policy and capital structure within business finance. It examines the dividend irrelevance theory, highlighting that dividend decisions do not affect a firm's value due to investors' ability to sell equity for cash. The essay also explores various capital structure theories, including the Net Income Approach, Net Operating Income Approach, Pecking Order Theory, and Modigliani-Miller Approach, each offering different perspectives on the relationship between debt, equity, and firm value. These theories provide a systematic framework for financing business activities and understanding the impact of financial leverage on a company's overall valuation. Desklib offers a wealth of resources, including past papers and solved assignments, to further assist students in mastering these complex concepts.

Running Head: BUSINESS FINANCE
BUSINESS FINANCE
Name of the Student
Name of the University
Author Note

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Table of Contents
Financing Decisions- Dividend Policy and Capital Structure....................................................2
Dividend Irrelevance..............................................................................................................2
Capital Structure Theories......................................................................................................3
Reference....................................................................................................................................5

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Financing Decisions- Dividend Policy & Capital Structure
The decisions of financing are the crucial one of the most crucial decisions that are
taken by financial manager in relation to the financing mix of organisation. The decisions are
related to the borrowing as well as allocations of the funds that are required for the decisions
of investment. The important decisions made by the business organisation includes
investment decisiosn, financing decisions and dividend decisions (Baker and Weigand 2015).
Capital Structure is defined as the way in which the buisness organisation finances their
assets with the help of combination of the debt, equity as well as hybrid securities. Capital
structure of the firm is the composition of the their overall liabilities. Moreover, dividend
policy is defined as determinition of the earnings division between the retained earning and
payments to the sharesholders (Hunjra et al. 2014).
Dividend Irrelevance
Dividend theory of irrelevance is the theory that considers the dividend decisions for
being irrelevant, it is because it does not help in affecting the value of the firm. This theory
holds the fact that the investors does not concers theirselve with the dividend policy of the
company because they are having the opportunity for selling their portion of the equity in cse
if they woulld like to have cash. The theory indicates that the declaration as well as the
payment of the dividend have the no or little impacts on the prices of the stock, which does
not add the value to the stock price of the company (Priya and Mohanasundari 2016). The
value of the firm depends upon the earnings of the firm and earning of the firm depends upon
the investment policy of the firm, but not on the dividend policy. Moreover, the firm that
pays higher dividends generally offers less appreciation of price but it must provides the same
return to the sharesholders given the risks characteristics of risk as well as cash flows from
the decisions of investments. Therefore, there are no taxes, and if the capital gains as well as
the dividends are taxed at same rate, the investors would be indifferent for receiving the

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returns in the price appreciations or the dividends. Henec, in the absence of tax, dividend is
irrelivent (Renneboog and Szilagyi 2015).
According to Modigliani F and Miller, the theory of dividend irrelevance is stated as
the dividend policy of the firm has no any impact on the value of the firm or their stock price.
The assumption on which it is dependent is based are perfectness of financial markets and the
sharesholders of the company construct their own policy of dividend by selling and buying
the shares in the market that is as per their desires. The irrelevance theory according to MM
assumes no brokerage fees or the capital gains of taxes (Miller and Modigliani 1961).
Capital Structure Theories
The capital structure theory are referred to the systematic approach to the financing
buisness activities by the combinations of the liabities and the equities. There are different
theories relating to the capital structure that explores relationship among the financing of
equity, financing of debt as well as firm’s market value that are slightly different.
Net Income Approach
This theory is suggested by the Durand, who was in the favor of the decion of
financial leaverage. As per him, any change in the financial leverage would lead to the
change in the cost of the capital. This theory explains that if the debt ratio in capital structure
increses thenm there would be decrease in the weighted average cost of the capital and
therefore there would be increase in the firm’s value.
Net Operating Income Approach
Durand has also provided this theory. It is just opposite to the theory of Net Income
Approach in case if there are no taxes. Under this theory, there is constant weighted average
cost of the capital. This theory believes that market analyses the firm as a whole as well it
discounts at the particular rate that has no relation to the ratio of debt-equity. If the

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information of the tax is given then it recommends that if there is increase in the debt-
financing, there would be reduction of WACC as well as firm’s value will start to increase
(Zeitun and Tian 2014).
Pecking Order Theory
This theory focusses on the asymmetrical costs of information. This theory assumes
that the company makes the priority of their financing strategy that are based on the path of
the least resistance. Under this, firstly the internal financing is followed that is then followed
by the debt and financing through the external equity is the last resort for this approach
(Danis, Rettl and Whited 2014).
Modigliani and Miller Approach
The fundamentals of the approach of Modigliani and Miler matches with the Net
operating income approach. As per MM advocated capital structure irrelevancy theory that
states that the firm’s valuation is irrelevant to the company’s capital structure. Whether the
firm leveraged highly or it has lower component of debt in their financing mix has no bearing
on the firm’s value. The approch by MM suggests that firm’s market value is affected by
their operating income apart from the risk that is involved in the investments. Hence, the
firm’s value is not dependent upon the capital structure choice or the firm’s financing
decisions (Miller and Modigliani 1961).
Therefore, it can be said that dividend irrelevance theory is the important and one of
the major theory that concerns the dividend policy of the company.

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Reference
Baker, H.K. and Weigand, R., 2015. Corporate dividend policy revisited. Managerial
Finance, 41(2), pp.126-144.
Danis, A., Rettl, D.A. and Whited, T.M., 2014. Refinancing, profitability, and capital
structure. Journal of Financial Economics, 114(3), pp.424-443.
Hunjra, A.I., Ijaz, M., Chani, D., Irfan, M. and Mustafa, U., 2014. Impact of Dividend Policy,
Earning per Share, Return on Equity, Profit after Tax on Stock Prices. Hunjra, AI, Ijaz, M. S,
Chani, MI, Hassan, S. and Mustafa, U.(2014). Impact of Dividend Policy, Earning per Share,
Return on Equity, Profit after Tax on Stock Prices. International Journal of Economics and
Empirical Research, 2(3), pp.109-115.
Priya, V. and Mohanasundari, M., 2016. Dividend Policy and Its Impact on Firm Value: A
Review of Theories and Empirical Evidence. Journal of Management Sciences and
Technology, 3(3), pp.59-69.
Miller, M. and Modigliani, F., 1961. Dividend policy, growth, and the valuation of shares.
Renneboog, L. and Szilagyi, P.G., 2015. How relevant is dividend policy under low
shareholder protection?. Journal of International Financial Markets, Institutions and Money.
Zeitun, R. and Tian, G.G., 2014. Capital structure and corporate performance: evidence from
Jordan. Australasian Accounting Business & Finance Journal, Forthcoming.