Dividend Irrelevance and Capital Structure Theories Report

This report provides a critical evaluation of dividend irrelevance and capital structure theories, starting with the foundational work of Modigliani and Miller (MM) and their theorem that, under certain assumptions, dividend policy is irrelevant to firm value. The report explores the MM theorem, examining its assumptions of perfect capital markets, no taxes, and fixed investment policies, while also acknowledging the limitations of these assumptions in the real world. It delves into the implications of corporate tax considerations and discusses how the MM theorem has been expanded to account for these factors. The report then examines dividend irrelevance theories, including the residual theory and the bird-in-the-hand theory, and contrasts these with the MM theorem. Furthermore, it analyzes various capital structure theories, such as the trade-off theory and the pecking order theory, highlighting their relevance in corporate finance. The conclusion acknowledges the contributions of MM while emphasizing the need for considering multiple factors when making decisions about capital structure and dividend policy in today's business environment. The report references key literature and provides a comprehensive overview of the subject matter.

Running head: DIVIDEND IRRELEVANCE AND CAPITAL STRUCTURE THEORIES 1
Dividend Irrelevance and Capital Structure Theories
Student’s Name
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DIVIDEND IRRELEVANCE AND CAPITAL STRUCTURE THEORIES 2
Introduction:
Capital structure is used to refer to the way a firm decides to finance its overall
business operations. There are different sources of funds which are categorisied as either debt
(liabilities) or equity. Dividend policy refers to the strategy a firm uses to structure its
dividend payout to its shareholders.
The theories pioneered by Modigliani and Miller (MM) were based on the abstract
question whether dividend policy has any impact on the value of a firm (Modigliani & Miller,
1958). The two professors, Modigliani and Miller (MM) suggested that the dividend policy
was irrelevant, under some unrealistic assumptions. The initial dividend irrelevance theory
has been revamped to include some more realistic assumptions. Researchers continue to
debate on the basic nature of a firm’s capital which is made up of debt and/or equity.
More theories have advanced the thinking of MM since it was published in 1958 and
subsequent paper in 1961, while others have strongly contrasted with the dividend irrelevance
and capital structure theories. This paper looks to critically evaluate on dividend irrelevance
and capital structure theories with a great emphasis on corporate tax consideration and firm
valuation in the contemporary world.
The Modigliani-Miller (MM) Theorem
The MM theorem ideally advances the notion that firm valuation is independent of
how the firm finances its operations or how it distributes its dividends, since the market value
of a firm is calculated using its earning power and the its business risk (Ahmeti & Prenaj,
2015). Modigliani and Miller argued that investors are more interested in capital appreciation
than receive annual dividends. According to the researchers, in a perfect capital market, if a
company retains its earnings instead of distributing the earnings as dividends, their
shareholders will be contented with capital appreciation which would equal the amount

DIVIDEND IRRELEVANCE AND CAPITAL STRUCTURE THEORIES 3
earnings were retained. Hence from the point of view of investors, it is irrelevant whether
they receive dividends or the company retains the earnings.
The MM theorem is only valid in a perfect capital market, hence the following
assumptions. The first assumption is that the capital markets are perfect, such that investors
are rational, there are no transactional costs, information is freely available, and no investor is
large enough to influence the stock price. Another assumption of the theorem was the taxes
are no existence or the taxes rates applicable to both capital gains and dividends are similar.
The third assumption is that the company has a fixed investment policy. Lastly, the theorem
assumes that there is no uncertainty on the company’s future prospects.
However, looking at the two critical assumptions that MM’s theory relies on for its
validity, it is clear that the theorem has no place in the contemporary word. In the real world,
taxes are part and parcel of every business operation. It is not economically viable to have
company’s run in a country without tax obligations. The federal state depends on taxes to run
its public policies and programs. The other unrealistic assumption is the lack of transactional
costs. This will never be tenable in the current world. Nonetheless, the propositions advanced
by the MM theorem gives the opportunity for companies to look beyond the capital structure
and critically determine the other factors that add value to their business (Ahmeti & Prenaj,
2015).
In their later work, Modigliani & Miller (1963), viewed that corporate tax was
significant in firm valuation. This is because although dividends and retained earnings were
not deductible under corporate tax, interest on debt was a tax deductible expense. Therefore,
firms were attracted to use debt financing, because the net income available for the
shareholders as well as the creditors was greater when debt capital was used. In other words,
the present value of the interest tax shield results to higher market firm value as the debt to
equity ratio rises. The theorem holds that the cost of capital is not affected even if the

DIVIDEND IRRELEVANCE AND CAPITAL STRUCTURE THEORIES 4
company chooses to use more and more leverage. However, consequent studies have found
out that firms will avoid a pure debt position despite the presence of corporate tax. Baxter
(1967) attributes this to the fact that the interest rate on debt is related to the debt- equity
ratio. In other words, creditors demand a higher rate of return from companies that borrow
more. Hence, debt becomes less attractive to firms despite the tax shield.
The Dividend Irrelevance Theories:
The Residual Theory:
This theory holds that dividends should be considered as residuals by the firms,
which is the earnings remaining after the firms has adequately financed all its prospective
projects using its retained earnings. Therefore, the theory suggests that dividends cannot be
used to measure the value of a firm because the firm should never forego desirable
investments projects to pay dividends. More so, investors are more concerned about the
future cash flows of the firm rather than whether the firm is paying dividends or not.
However, there is no empirical evidence to support the residual theory, but it stems from the
logical decision point for any firm to meet its financing needs before paying out dividends.
There is a similarity between MM dividend irrelevance theory and the residual
theory, which is also referred to as the traditional theory. MM’s theory holds that dividends
distributed from earnings with a zero NPV have no effect on the value of the firm. From the
traditional theory, earnings with zero NPV are considered residuals, and when distributed as
dividends they do not affect the firm’s value. However, the question remains whether the
value of companies that follow a strict residual dividend policy is affected in the real world.
The bird-in-the-hand theory contradicts the notion of the dividend irrelevance and
residual theory, that investors are have no preference over getting dividend payouts today or
enjoy capital gains much later. The bird-in-the-hand theory postulates that stockholders
would prefer a more certain dividend today to a more uncertain capital gain later. Therefore,

DIVIDEND IRRELEVANCE AND CAPITAL STRUCTURE THEORIES 5
companies should be aware that there are investors who would rather a high dividend payout,
even if it means low growth in the future of the company. Consequently, the high current
payout pattern desired by such investors match a lower required rate of return which results
in higher share prices for the firms.
The Capital Structure Theories:
The Trade-Off Theory:
Under the trade-off theory, Kraus and Litzenberger (1973) posit that company
decide on their optimal capital structure by weighing the costs and benefits of an additional
dollar of debt. The aim of the company is to have an optimal leverage ratio at minimum cost
and attain maximum benefits. This theory is an improvement of MM’s theory on the
assumption of no taxes. The trade-off theory recognizes that in the real world, majority of the
countries are big on corporate tax. Hence, a cost benefit trade off, where borrowed funds are
tax deductible, but there are costs of potential bankruptcy.
The Pecking Order Theory:
The pecking order theory suggests internal sources of financing such as retained
earnings are preferable to debt as a source of financing (Frank & Goyal, 2009). The theory
suggests that a firm will exhaust its retained earnings as a source of financing its desirable
investment project, before considering debt financing, and the last resort will be equity
financing. Myers (1984) urges that managers do not really like to raise capital from equity
because when the managers do, investors think that the firm is over-valued so they will
always place a lower value for a new equity issuance.
Many researchers have carried out different studies to examine the validity of the
pecking order theory in the real world. A study by Helwege and Liang (1996) examined the
capital structure of 500 small companies that were listed in 1983. The study found out that
the firms did not follow the pecking order in sourcing for external financing through equity.

DIVIDEND IRRELEVANCE AND CAPITAL STRUCTURE THEORIES 6
On the contrary, some studies have found out that the pecking order theory play an important
role when mangers of different companies are explaining their financing decisions (Leary &
Roberts, 2010; Flannery & Rangan, 2006).
Conclusion:
We acknowledge that Modigliani and Miller are pioneers in the corporate finance
world, and their works are vital in the research of capital structure and dividend policy for
generations to come. However, the capital structure theories have underlying assumptions
that are greatly challenged in the contemporary world. In the real world, companies have to
consider several factors before making decision about their capital structure. These factor
included financial flexibility, tax position, managerial attitude, and business and financial
risk. In the real world, interest on debt is tax deductible, which makes financing through debt
an attractive preposition. However the firm must be worry of its liquidity ratios. Similarly,
dividend policy is influenced by various factors in the real world such as the liquidity positon
of a company, investment opportunities, cost of equity, and constrains on dividend payments.
Conclusively, Modigliani and Miller theories are not valid in the contemporary
world, but they offer the opportunity for further research and improvement of theories
regarding capital structure and dividend policy irrelevance.

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References
Ahmeti, F., & Prenaj, B. (2015). A critical review of Modigliani and Miller’s theorem of
capital structure. International Journal of Economics, Commerce and Management
(IJECM), 3(6).
Baxter, N. D. (1967). Leverage, risk of ruin and the cost of capital. the Journal of
Finance, 22(3), 395-403.
Flannery, M. J., & Rangan, K. P. (2006). Partial adjustment toward target capital
structures. Journal of financial economics, 79(3), 469-506.
Frank, M. Z., & Goyal, V. K. (2009). Capital structure decisions: which factors are reliably
important?. Financial management, 38(1), 1-37.
Helwege, J., & Liang, N. (1996). Is there a pecking order? Evidence from a panel of IPO
firms. Journal of financial economics, 40(3), 429-458.
Kraus, A., & Litzenberger, R. H. (1973). A state‐preference model of optimal financial
leverage. The journal of finance, 28(4), 911-922.
Leary, M. T., & Roberts, M. R. (2010). The pecking order, debt capacity, and information
asymmetry. Journal of financial economics, 95(3), 332-355.
Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the
theory of investment. The American, 1, 3.
Modigliani, F., & Miller, M. H. (1963). Corporate income taxes and the cost of capital: a
correction. The American economic review, 53(3), 433-443.
Myers, S. C. (1984). The capital structure puzzle. The journal of finance, 39(3), 574-592.