Question

Erin and Mia are finance researchers and are discussing the Modigliani and Miller (MM) divident irrelevance theory. Based on your understanding of MM's arguement and the impact fo the assumptions applied to the arguement, fill in the missing parts of their conversation.

Erin: Modigliani and Miller (MM) divident irrelevance theory is based on several assumptions, however, in the real world these assumptions do not apply.

Mia: Issuance or flotation costs impact divident policy decisions, and companies do not care about whether to retain earnings or distribute dividends.

Erin: You are right Mia. Due to the issuance costs with new equity sales, companies tend to make (earnings retention or dividend payout) more desirable.

Mia: If a company pays out dividends and needs funds to invest in profitable projects, it would need to generate capital through new stock issues which is (more or less) expensive than using internal cash flow.

Answer 1

1. Erin: You are right Mia. Due to the issuance costs with new equity sales, companies tend to make earnings retention more desirable.

Explanation: It is a financial fact that if earnings are retained then no flotation costs are involved. On the other hand if new shares are issued then the firm will have to incur expenses like broker’s commission and under writing fee. Therefore if flotation costs are considered then retention of earnings would be favored over payment of dividends.

2. Mia: If a company pays out dividends and needs funds to invest in profitable projects, it would need to generate capital through new stock issues which is more expensive than using internal cash flow.

Explanation: This is because using internal cash flow does not require a firm to pay for expenses like commission to brokers and fees to under writers.