A Critique

Modigliani and Miller argue that the dividend decision of the firm is irrelevant in the sense that the value of the firm is independent of it. The crux of their argument is that the investors are indifferent between dividend and retention of earnings. This is mainly because of the balancing nature of internal financing (retained earnings) and external financing (raising of funds externally) consequent upon distribution of earnings to finance investment programmes. Whether the MM hypothesis provides a satisfactory framework for the theoretical relationship between dividend decision and valuation will depend, in the ultimate analysis, on whether external and internal financing really balance each other. This, in turn, depends upon the critical assumptions stipulated by them. Their conclusions, it may be noted, under the restrictive assumptions, are logically consistent and intuitively appealing. But these assumptions are unrealistic and untenable in practice. As a result the conclusion that dividend payments and other methods of financing exactly offset each other and, hence, the irrelevance of dividends, is not a practical proposition; it is merely of theoretical relevance. The validity of the MM Approach is open to question on two counts: (i) Imperfection of capital market, and (ii) Resolution of uncertainty.

Market Imperfection

Modigliani and Miller assume that capital markets are perfect. This implies that there are no taxes, flotation costs do not exist and there is absence of transaction costs. These assumptions are untenable in actual situations.

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