Question

Suppose a firm “Mechanical Precisions” is keeping the payout ratio at 30 percent, and is making capital investments on a regular basis. Another firm “Stable Furniture” has not made any investment in the past 10 years and its payout ratio is 90 percent. The total value of “Mechanical Precisions” is currently £15 million and it has a debt of £6 million, while the total value of “Stable Furniture” is £6 million and it has a debt of £4 million. Both firms can borrow at the same interest rate and the same effective tax rate is applied to them.

a) Explain whether the predictions of the pecking order theory are consistent with the above. In doing so, you should explain explicitly what the informational asymmetry is, who possesses private information, and what the implications are. [25 marks]

b) Explain whether the predictions of Modigliani-Miller’s argument on dividend policy are consistent with the above. [10 marks]

c) What can we say about the costs of financial distress if the predictions of the tradeoff theory are consistent with the case of “Mechanical Precisions” and “Stable Furniture”?

Answer 1

1 (b) The predictions of the Modigliani Miller model is consistent with the above. The MM model states that, th valueof the firm does not depend on th amount of dividen paid by it. In this case also, the 2 firms have different dividend payout policy &so the valueof the firms are also different. people can also generate home made dividends with the amount of money paid by the Company.

1 (c) The interest rates are same, but still Mechanical is more valuable than Stable. Mechanicalis using more of internal accruals for financing its capital expenditure whereas Stable is relying more on outside borrowings.