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Flotation Cost

Another assumption of a perfect capital market underlying the MM hypothesis is dividend irrelevance is the absence of flotation costs. The flotation cost refers to the cost involved in capital from the market, for instance, underwriting commission, brokerage and other expenses. The presence of flotation costs affects the balancing nature of internal (retained earnings) and external (dividend payments) financing. The MM position, it may be recalled, argues that given the investment decision of the firm, external funds would have to be raised equal to the amount of dividend, through the sale of new shares to finance the Investment programmed. The two methods of financing are not perfect substitutes because of flotation costs. The introduction of such cost, implies that the net proceeds from the sale of new shares would be less than the face value of the shares, depending upon their size. It means that to be able to make use of external funds, equivalent to the dividend payments, the firm would have to sell shares for an amount in excess of retained earnings. In other word external financing through sale of shares would be costlier than internal financing retained earnings. The smaller the size of the issue, the greater is the percentage flotation cost? To illustrate, suppose the cost of flotation is 10 per cent and the retained earnings are Rs 900. In case dividends are paid, the firm will have to sell shares worth Rs 1,000 to raise funds equivalent to the retained earnings. That external financing is costlier is another way of saying that firms would prefer to retain earnings rather than pay dividends and then raise funds externally.

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