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Miller and Modigliani Irrelevance Theory

Autor:   •  March 18, 2011  •  Essay  •  1,343 Words (6 Pages)  •  2,145 Views

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Miller and Modigliani are part of the economist's school of thought who advocates the "earning theories". The model is based on discounted retain earnings. (The dividend policy is treated as passive residual).

Earnings theoreticians include Miller and Modigliani (1958, 1961, 1963); Walter, J (1956) Fama, E. (1974); Black, F and Scholes, M. (1974); etc.

In one of the most debated paper, Miller and Modigliani have demonstrated that the market value of the firm is independent of its dividend policy, therefore dividends are "irrelevant", and furthermore equity holders are indifferent about the firm's financial policy.

It is important to underline that Miller and Modigliani's theoretical model is based on the following assumptions:

i) The investment policy is held constant (which will not change the nature of the risk neither the rate of return) and the firm operates in a "perfect and efficient market" where there are not taxes or transaction costs.

ii) The stock is fairly priced, the securities are infinitely divisible and hence not single investor is big enough to influence the share price.

iii) Miller and Modigliani, also assume that the companies are financed only by equity (ordinary shares) in two ways by retaining earnings or issues of new shares

iv) The last assumption is that the (rational) investors can freely access to all the information in a same way that the firm does. Therefore he will be able to forecast the future price of the shares with certainty. (Brealey, R. Myers, S. and Allen, F. 2008)

Based on these assumptions, two of their arguments arise: the first one is that "dividend policies do not affect firm value".

Since the market value of the firm is given by the sum of the present value of forecasted cash flows according to Miller and Modigliani, attention should be focus only on the "investment decision" and the return on the investment, which is seen as part of the financing decision and it is not linked to the dividend decision.

The firm should accept all projects with positive NPV and this of course is only possible in a perfect capital market with conventional cash flow.

Miller and Modigliani argument although it seems complicated in theory is very logical. The firm needs to invest the free cash flow at an internal rate of return (IRR) which is higher than the cost of capital (equity) in order to achieve always a positive NPV (in this case will be NPV = 0).

Of course this prediction would not be possible if the cash flows were unconventional.

Since no firm would bypass on a positive NPV project

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