Question

M&M theory argues that dividend policy is irrelevant, while the information content of dividends asserts that stock price generally rises when the firm announces a dividend increase. Do the two theories contradict each other? Why or why not?

Answer 1

M & M Theory works on few assumption which are as follows:

1. Perfect Capital Market : M & M theory rely that there is perfect capital market in economy. Capital is easily available and also at no transaction costs. Also there are no majority invertors which influence the market price of capital.

2. Zero/ No taxes : Theory works on the assumption that there are no taxes in the market.

3. Constant investment policy : Constant investment policy followed by the company even in the risk based projects. This theory rely that investment policy doesn't vary from project to project, risk to risk.

4. Predictable future profits: M & M theory in on the basis of constant and certain future profits which leads to certain amount of investments, profits and dividends.

M & M theory that Investment policy derives the price in market is based on above state assumptions where as it is true that dividend influence the market price of shares of company so do market value.

M & M policy totally contradict as all the assumptions taken by theory are irrelevant in real time situations.

There is no capital market exists in real time where capital available without any transaction cost. Certain types of commissions, brokerage, etc are to be paid to generate capital from the market.

Also in real time situations, investors selloff their investment if no dividends are paid to them during the period of investments. Further assumption of certain future profits is totally irrelevant. Future is not predictable and internal and external force always leads to effect on working cost of company which lastly effect on profits.

On the other side if a company is known for higher returns in the form of dividends it post higher share prices specially during the finalisation of financial statements and time of announcement of profits and further dividends. Dividend policy of a company is to decide how much from the earning are to plough back into business and what part is to be distributed.

So policies other than M & M always contradict as M & M is not relevant in real time situations because Investment policy directly related to dividend policy.

As if company getting more returns than cost of capital, they would keep earnings into business and make zero payout. This leads to less opportunity to shareholders by reinvesting. Further in reverse case where returns from business is less than cost of capital than company should distribute its earnings in the form of dividend as shareholders have better opportunities than firm from re-investment.

Contradictions of assumptions among the theories leads to irrelevant of M & M Theory against others.