Meaning and Concept of Capital Structure:

The term ‘structure’ means the arrangement of the various parts. So capital
structure means the arrangement of capital from different sources so that the long-
term funds needed for the business are raised.

Thus, capital structure refers to the proportions or combinations of equity share

capital, preference share capital, debentures, long-term loans, retained earnings and
other long-term sources of funds in the total amount of capital which a firm should
raise to run its business.

Few definitions of capital structure given by some financial experts:

“Capital structure of a company refers to the make-up of its capitalisation and it
includes all long-term capital resources viz., loans, reserves, shares and bonds.”—
Gerstenberg.

“Capital structure is the combination of debt and equity securities that comprise a
firm’s financing of its assets.”—John J. Hampton.

“Capital structure refers to the mix of long-term sources of funds, such as,
debentures, long-term debts, preference share capital and equity share capital
including reserves and surplus.”—I. M. Pandey.

Capital Structure, Financial Structure and Assets Structure:

The term capital structure should not be confused with Financial structure and
Assets structure. While financial structure consists of short-term debt, long-term
debt and share holders’ fund i.e., the entire left hand side of the company’s Balance
Sheet. But capital structure consists of long-term debt and shareholders’ fund.

So, it may be concluded that the capital structure of a firm is a part of its financial
structure. Some experts of financial management include short-term debt in the
composition of capital structure. In that case, there is no difference between the
two terms—capital structure and financial structure.

So, capital structure is different from financial structure. It is a part of financial

structure. Capital structure refers to the proportion of long-term debt and equity in
 the total capital of a company. On the other hand, financial structure refers to the
net worth or owners’ equity and all liabilities (long-term as well as short-term).

Capital structure does not include short-term liabilities but financial structure
includes short-term liabilities or current liabilities.

Assets structure implies the composition of total assets used by a firm i.e., make-up
of the assets side of Balance Sheet of a company. It indicates the application of
fund in the different types of assets fixed and current.

Assets structure = Fixed Assets + Current Assets.

TRADITIONAL PROPOSITION VS MM PROPOSITION OF CAPITAL

STRUCTURE:

The traditional approach to capital structure assumes that an increase in the

proportion of debt to some extent does not result in an increase in the cost of
equity, i.e., it remains fixed or grows slightly. That is the reason why it becomes
possible to reduce the weighted average cost of capital (WACC) by increasing the
proportion of debt financing in total capital. Thus, firms using financial leverage
within certain limits are valued higher by the market than similar companies with
lower financial leverage.
Assumptions
The traditional theory of capital structure is based on the following assumptions:
1. Cost of debt (kd) remains stable with an increase in the debt ratio to a certain limit
after which it begins to grow.
2. Cost of equity (ke) remains stable or grows slightly with an increase in the debt
ratio to a certain limit after which it begins to grow rapidly.
3. Weighted average cost of capital decreases to some degree with an increase in the
debt ratio and then begins to grow.
4. Cost of equity is larger than the cost of debt at any capital structure, i.e., k e>kd at
any value of debt ratio.
5. The traditional approach to capital structure believes the existence of optimal
capital structure. It is such a mix of debt and equity at which WACC reaches the
minimal value and the value of a firm will be maximized.
Graphs
Assumptions of the traditional approach to capital structure are illustrated in the
figure below.
 Modigliani and Miller approach to capital theory, devised in the 1950s
advocates capital structure irrelevancy theory. This suggests that the valuation of a
firm is irrelevant to the capital structure of a company. Whether a firm is highly
leveraged or has lower debt component, it has no bearing on its market value.
Rather, the market value of a firm is dependent on the operating profits of the
company.
The capital structure of a company is the way a company finances its assets. A
company can finance its operations by either equity or different combinations of
debt and equity. The capital structure of a company can have a majority of the debt
component or a majority of equity or a mix of both debt and equity. Each approach
has its own set of advantages and disadvantages. There are various capital structure
theories, trying to establish a relationship between the financial leverage of a
company (the proportion of debt in the company’s capital structure) with its market
value. One such approach is the Modigliani and Miller Approach.
This approach was devised by Modigliani and Miller during 1950s. The
fundamentals of Modigliani and Miller Approach resemble that of Net Operating
Income Approach. Modigliani and Miller advocate capital structure irrelevancy
theory. This suggests that the valuation of a firm is irrelevant to the capital
structure of a company. Whether a firm is highly leveraged or has lower debt
component in the financing mix, it has no bearing on the value of a firm.
Modigliani and Miller Approach further states that the market value of a firm is
affected by its operating income apart from the risk involved in the investment.
The theory stated that the value of the firm is not dependent on the choice of
capital structure or financing decision of the firm.

ASSUMPTIONS OF MODIGLIANI AND MILLER APPROACH

▪ There are no taxes.
▪ Transaction cost for buying and selling securities as well as bankruptcy cost is nil.
▪ There is symmetry of information. This means that an investor will have access to
the same information that a corporation would and investors would behave
rationally.
▪ The cost of borrowing is the same for investors as well as companies.
▪ There is no floatation cost like underwriting commission, payment to merchant
bankers, advertisement expenses, etc.
▪ There is no corporate dividend tax.
Modigliani and Miller Approach indicates that value of a leveraged firm ( a firm
which has a mix of debt and equity) is the same as the value of an unleveraged firm
( a firm which is wholly financed by equity) if the operating profits and future
prospects are same. That is, if an investor purchases shares of a leveraged firm, it
would cost him the same as buying the shares of an unleveraged firm

Modigliani and miller approach: two propositions without taxes

PROPOSITION 1
With the above assumptions of “no taxes”, the capital structure does not influence
the valuation of a firm. In other words, leveraging the company does not increase
the market value of the company. It also suggests that debt holders in the company
and equity shareholders have the same priority i.e. earnings are split equally
amongst them.
PROPOSITION 2
It says that financial leverage is in direct proportion to the cost of equity. With an
increase in debt component, the equity shareholders perceive a higher risk to for
the company. Hence, in return, the shareholders expect a higher return, thereby
increasing the cost of equity. A key distinction here is that proposition 2 assumes
that debt-shareholders have upper-hand as far as the claim on earnings is
concerned. Thus, the cost of debt reduces.
NOTE : DRAW THE DIAGRAM FROM NOTE BOOK

When corporate taxes are assumed to exist (theory of relevance):

Modigialni and Miller , in their article of 1963 have recognized that the value of
the firm will increase or the cost of capital will decrease with the use of debt on
account of deductibility of interest charges for tax purpose. Thus, the optimal
capital structure can be achieved by maximizing the debt mix in the equity firm.

According to MM Approach, the value of firm unlevered can be calculated as

(formula)

VALUE OF UNLEVERED FIRM (VU): EARNINGS BEFORE INTEREST AND

TAX (1-T)/ OVERALL COST OF CAPITAL

VALUE OF LEVERED FIRM (VL): VALUE OF UNLEVERED FIRM + Td

Where, VU = value of unlevered firm, t D= Is the discounted present value of tax

savings resulting from the tax deductibility of the interest charges, t= the rate of tax
and D= quantum of debt used in the mix.

NOTE: DRAW THE DIAGRAM OF LEVERED AND UNLEVERED FIRM

FROM THE NOTE BOOK

IMPORTANCE OF CAPITAL STRUCTURE:

The importance or significance of Capital Structure:

1. Increase in value of the firm:

A sound capital structure of a company helps to increase the market price of shares and
securities which, in turn, lead to increase in the value of the firm.

2. Utilization of available funds:

A good capital structure enables a business enterprise to utilise the available funds fully.
A properly designed capital structure ensures the determination of the financial
requirements of the firm and raise the funds in such proportions from various sources
for their best possible utilisation. A sound capital structure protects the business
enterprise from over-capitalisation and under-capitalisation.

3. Maximisation of return:
A sound capital structure enables management to increase the profits of a company in
the form of higher return to the equity shareholders i.e., increase in earnings per share.
This can be done by the mechanism of trading on equity i.e., it refers to increase in the
proportion of debt capital in the capital structure which is the cheapest source of capital.
If the rate of return on capital employed (i.e., shareholders’ fund + long- term
borrowings) exceeds the fixed rate of interest paid to debt-holders, the company is said
to be trading on equity.

4. Minimisation of cost of capital:

A sound capital structure of any business enterprise maximises shareholders’ wealth
through minimisation of the overall cost of capital. This can also be done by
incorporating long-term debt capital in the capital structure as the cost of debt capital is
lower than the cost of equity or preference share capital since the interest on debt is tax
deductible.

5. Solvency or liquidity position:

A sound capital structure never allows a business enterprise to go for too much raising
of debt capital because, at the time of poor earning, the solvency is disturbed for
compulsory payment of interest to .the debt-supplier.

6. Flexibility:
A sound capital structure provides a room for expansion or reduction of debt capital so
that, according to changing conditions, adjustment of capital can be made.

7. Undisturbed controlling:
A good capital structure does not allow the equity shareholders control on business to be
diluted.

8. Minimisation of financial risk:

If debt component increases in the capital structure of a company, the financial risk (i.e.,
payment of fixed interest charges and repayment of principal amount of debt in time)
will also increase. A sound capital structure protects a business enterprise from such
financial risk through a judicious mix of debt and equity in the capital structure.

FACTORS AFFECTING CAPITAL STRUCTURE:

1. Financial Leverage or Trading on Equity:

The word ‘equity’ denotes the ownership of the company. Trading on equity means
taking advantage of equity share capital to borrowed funds on reasonable basis. It
refers to the additional profits that equity shares earn because of funds raised by
issuing other forms of securities, viz., preference shares and debentures.

It is based on the premise that if the rate of interest on borrowed capital and the
rate of dividend on preference capital are lower than the general rate of company’s
earnings, the equity shareholders will get advantage in the form of additional
profits. Thus, by adopting a judicious mix of long-term loans (debentures) and
preference shares with equity shares, return on equity shares can be maximized.

Trading on equity is possible under the following conditions:

(i) The rate of company’s earnings is higher than the rate of interest on debentures
and the rate of dividend on preference shares.

(ii) The company’s earnings are stable and regular to afford payment of interest on
debentures.

(iii) The company has sufficient assets which can be used as security to raise
borrowed funds.

2. Expected Cash Flows:

Debentures and preference shares are often redeemable, i.e., they are to be paid
back after their maturity. The expected cash flows over the years must be sufficient
to meet the interest liability on debentures every year and also to return the
maturity amount at the end of the term of debentures. Thus, debentures are not
suitable for those companies which are likely to have irregular cash flows in future.
3. Stability of Sales:
Stability of sales turnover enhances the company’s ability to pay interest on
debentures. If sales are rising, the company can use more of debt capital as it
would be in a position to pay interest. But if sales are unstable or declining, it
would not be advisable to employ additional debt capital.

4. Control over the Company:

The equity shareholders are considered as the owners of the company and they
have complete control over the company. They take all the important decisions for
managing the company. The debenture holders have no say in the management and
preference shareholders have limited right to vote in the annual general meeting.
So the total control of the company lies in the hands of equity shareholders.

If the owners and existing shareholders want to have complete control over the
company, they must employ more of debt securities in the capital structure because
if more of equity shares are issued then another shareholder or a group of
shareholders may purchase many shares and gain control over the company.

Equity shareholders select the directors who constitute the Board of Directors and
Board has the responsibility and power of managing the company. So if another
group of shareholders gets more shares then chance of losing control is more.

5. Flexibility of Financial Structure:

A good financial structure should be flexible enough to have scope for expansion
or contraction of capitalization whenever the need arises. In order to bring
flexibility, those securities should be issued which can be paid off after a number
of years.

Equity shares cannot be paid off during the life time of a company. But redeemable
preference shares and debentures can be paid off whenever the company feels
necessary. They provide elasticity in the financial plan.

6. Nature and the size of firm:

Nature and the size of the firm can also influence its capital structure. Public utility
concern can employ more of debt because of the stability of earnings. On the other
hand , a concern and which cannot provide stable earnings due ti the nature of
business will rely mainly on the equity capital. Similarly small companies have to
rely mainly upon their own capital as it is very difficult for them to raise long term
loans.

7. Period of Financing:

The period of finance are required is also an important factor to be kept in mind
while selecting an appropriate capital structure. When funds are required for
permanent investment in a company, equity share capital is preferred. When the
finance is required for a limited period of say seven years, debentures should be
preferred. Redeemable preference shares may also be used for a limited period
of finance.

8. Market Conditions:
The conditions prevailing in the capital market influence the determination of the
securities to be issued. For instance, during depression, people do not like to take
risk and so are not interested in equity shares. But during boom, investors are ready
to take risk and invest in equity shares. Therefore, debentures and preference
shares which carry a fixed rate of return may be marketed more easily during the
periods of low activity.

9. Types of Investors:
The capital structure is influenced by the likings of the potential investors.
Therefore, securities of different kinds and varying denominations are issued to
meet the requirements of the prospective investors. There are three types of
investors:

Bold investors: are willing to take all types of risk, are enterprising in the nature
and prefer capital gain and control and hence equity share capital is best suited to
them.
Over-Cautious investors: prefer safety of investment and stability in returns and
hence debtures should satisfy such investors.

Less cautious investors: they would prefer preference share capital which provides
stability in return.

10. Legal Requirements:

The structure of capital of a company is also influenced by the statutory
requirements. For instance, banking companies have been prohibited by the
Banking Regulation Act to issue any type of securities except equity shares.

11. Corporate tax rate:

High corporate taxes on profit compel the companies to prefer debt financing,
because interest is allowed to be deducted while computing taxable profits. On the
other hand, dividend on shares is not an allowable expense for that purpose.

Meaning of Dividend Policy:

The term dividend refers to that part of profits of a company which is distributed
by the company among its shareholders. It is the reward of the shareholders for
investments made by them in the shares of the company. The investors are
interested in earning the maximum return on their investments and to maximize
their wealth. A company, on the other hand, needs to provide funds to finance its
long-term growth.

If a company pays out as dividend most of what it earns, then for business
requirements and further expansion it will have to depend upon outside resources
such as issue of debt or new shares. Dividend policy of a firm, thus affects both the
long-term financing and the wealth of shareholders.

As a result, the firm’s decision to pay dividends must be reached in such a manner
so as to equitably apportion the distributed profits and retained earnings.

Since dividend is a right of shareholders to participate in the profits and surplus of

the company for their investment in the share capital of the company, they should
receive fair amount of the profits. The company should, therefore, distribute a
reasonable amount as dividends (which should include a normal rate of interest
plus a return for the risks assumed) to its members and retain the rest for its growth
and survival.

Objectives of Dividend Policy:

Dividend policy refers to the decision of the board regarding distribution of
residual earnings to its shareholders. The primary objective of a finance manager is
the maximization of wealth of the shareholders. Payment of dividend leads to
increase in the price of shares on the one hand but leads to a crunch in liquid
resources for financing of prospective projects. There is an inverse relationship
between dividend payment and retained earnings.

The main objectives of a dividend policy are:

i. Wealth Maximization:
According to some schools of thought dividend policy has significant impact on
the value of the firm. Therefore the dividend policy should be developed keeping
in mind the wealth maximization objective of the firm.

ii. Future Prospects:

Dividend policy is a financing decision and leads to cash outflows and also leads to
decrease in availability of cash for financing of profitable projects. If sufficient
funds are not available, a firm has to depend on external financing. Therefore the
dividend policy needs to be devised in such a manner that prospective projects may
be financed through retained earnings.

iii. Stable Rate of Dividend:

Fluctuation in the rate of return adversely affects the market price of shares. In
order to have a stable rate of dividend, a firm should retain a high proportion of
earnings so that the firm can keep sufficient funds for payment of dividend when it
faces loss.

iv. Degree of Control:

Issue of new shares or dependence on external financing will dilute the degree of
control of the existing shareholders. Therefore, a more conservative dividend
 policy should be followed in order that the interest of existing shareholders is not
hampered.

Forms of dividend policy:

There are basically 4 types of dividend policy. Let us discuss them on by one:

1.) Regular dividend policy:

In this type of dividend policy the investors get dividend at usual rate. Here the
investors are generally retired persons or weaker section of the society who want to
get regular income. This type of dividend payment can be maintained only if the
company has regular earning.

Merits of Regular dividend policy:

• It helps in creating confidence among the shareholders.

• It stabilizes the market value of shares.
• It helps in marinating the goodwill of the company.
• It helps in giving regular income to the shareholders.

2) Stable dividend policy:

Here the payment of certain sum of money is regularly paid to the shareholders.
The term stability of dividend means consistency or lack of variability in the
stream of dividend payments.. in more precise terms, it means payment of certain
minimum amount of dividend regularly. It is of three types:

a Constant dividend per share:

Some companies follow a policy of paying fixed dividend per share irrespective of
the level of earnings year after year. It is suitable for the firms having stable
earning. Such firms usually create a reserve for dividend equalization to enable
them to pay the fixed dividend even in the year when the earnings are not sufficient
or when there are losses. A policy of constant dividend per share is most suitable to
concerns whose earnings are expected to remain stable over the years.

b Constant payout ratio:

 It means the payment of fixed percentage of net earnings as dividend every year.
The amount of dividend is such policy fluctuates in direct proportion to the
earnings of the company. The policy of constant pay out is preferred y the firms
because it is related to their ability to pay dividends. The figure given below shows
the behavior of dividends when such a policy is followed:

c. Stable rupee dividend plus extra dividend:

It means the payment of low dividend per share constantly + extra dividend in the
year when the company earns high profit. Such a policy is most suitable to the firm
having fluctuationg earnings from year to year.

Merits of stable dividend policy:

• It helps in creating confidence among the shareholders.

• It stabilizes the market value of shares.
• It helps in marinating the goodwill of the company.
• It helps in giving regular income to the shareholders.
• It improves the credit standing and makes financing easier.

3) Irregular dividend:
As the name suggests here the company does not pay regular dividend to the
shareholders. This policy is based on management’s belief that shareholders are
entitled to dividend only when earning and liquidity position of the firm warrant.
Generally, this policy is adopted by firms with unstable earnings. Firms with
fluctuating investment opportunities may find this policy useful. A large part of
profits may be ploughed back in the year when a firm has number of highly
profitable investment opportunities. In the subsequent year, when the firm has no
or limited investment opportunities to seize, the management may distribute larger
portion of earnings which would otherwise have remained unutilized.

The company uses this practice due to following reasons:

• Due to uncertain earning of the company.
• Due to lack of liquid resources.
• The company sometime afraid of giving regular dividend.
• Due to not so much successful business.

4) No dividend policy:
The company may use this type of dividend policy due to requirement of funds for
the growth of the company or for the working capital requirement. Very often
management may decide to declare no dividend despite large earnings of the firm.

This policy is generally pursued in the following circumstances:

1. A new and rapidly growing concern which needs tidy amount of funds to
finance the expansion programmes.

2. When the firm’s access to capital market is difficult or when availability of

funds is costlier.

3. Where shareholders have agreed to accept higher return in future or they have
strong preference for long-term capital gains as opposed to short-term dividend
income.

Policy of no immediate dividends should be followed by issue of bonus shares so

that the firm’s capital increases and amount of reserves and surplus is reduced or
the firm’s stock should be split into small lots so as to keep dividend per share low
while providing large dividend amounts to stockholders.

This course of action would be necessary to keep share prices within limits.
Detailed account of significance of stock dividends has been given under the
heading stock dividends.

Conclusion
A dividend policy serves the purpose of guiding the company on how and when to
pay dividends to its investors. This is important because studies show that
stakeholders are more likely to invest more in a company that pays dividends to its
investors since paying dividends is viewed as a sign of the company’s good health.
Such a company also attracts potential investments, generates additional funds and
increases stakeholder wealth. However, it is important to note that a business needs
to choose the most suitable approach for the firm in regards to its financial status in
the past and the expected earnings in the future as well as the internal needs of the
company. The residual approach is most suitable for enterprises that need
additional capital. The company’s priority is to reinvest the earnings into the
business, a remainder of which will be distributed in the form of dividends to the
stakeholders. A firm that makes enough earnings to pay its stakeholders at a low
rate could adopt the stable approach. The firm is required to pay its stakeholders
dividends at fixed rates, which is usually low. The hybrid approach pays low fixed
rate dividends to its stakeholders and extra earnings after the business’ needs have
been met. This assures that the stakeholders receive dividends regardless of how
the company is performing. Several theories have been developed by economists
on the relevance of dividend policies to the stakeholder. These theories include the
optimal dividend theory, tax-preference dividend theory, dividend irrelevance
theory and dividend relevance theory.

THE FACTORS AFFECTING DIVIDEND POLICY:

1. Stability of Earnings:
Stability of earnings is one of the important factors influencing the dividend policy. If
earnings are relatively stable, a firm is in a better position to predict what its future
earnings will be and such companies are more likely to pay out a higher percentage of its
earnings in dividends than a concern which has a fluctuating earnings.
Generally, the concerns which deal in necessities suffer less from fluctuating incomes
than those concern which deal with fancy or luxurious goods.
2. Financing Policy of the Company:
Dividend policy may be affected and influenced by financing policy of the company. If
the company decides to meet its expenses from its earnings, then it will have to pay less
dividend to shareholders. On the other hand, if the company feels, that outside
borrowing is cheaper than internal financing, then it may decide to pay higher rate of
dividend to its shareholder. Thus, the internal financing policy of the company
influences the dividend policy of the business firm.
3. Liquidity of Funds:
The liquidity of funds is an important consideration in dividend decisions. According to
Guthmann and Dougall, although it is customary to speak of paying dividends ‘out of
profits’, a cash dividend only be paid from money in the bank. The presence of profit is
an accounting phenomenon and a common legal requirement, with the -cash and
working capital position is also necessary in order to judge the ability of the corporation
to pay a cash dividend.
Payment of dividend means, a cash outflow, and hence, the greater the cash position
and liquidity of the firm is determined by the firm’s investment and financing decisions.
While the investment decisions determine the rate of asset expansion and the firm’s
needs for funds, the financing decisions determine the manner of financing.
4. Dividend, Policy of Competitive Concerns:
Another factor which influences, is the dividend policy of other competitive concerns in
the market. If the other competing concerns, are paying higher rate of dividend than this
concern, the shareholders may prefer to invest their money in those concerns rather
than in this concern. Hence, every company will have to decide its dividend policy, by
keeping in view the dividend policy of other competitive concerns in the market.
5. Past Dividend Rates:
If the firm is already existing, the dividend rate may be decided on the basis of dividends
declared in the previous years. It is better for the concern to maintain stability in the
rate of dividend and hence, generally the directors will have to keep in mind the rate of
dividend declared in the past.
6. Debt Obligations:
A firm which has incurred heavy indebtedness, is not in a position to pay higher
dividends to shareholders. Earning retention is very important for such concerns which
are following a programme of substantial debt reduction. On the other hand, if the
company has no debt obligations, it can afford to pay higher rate of dividend.
7. Ability to Borrow:
Every company requires finance both for expansion programmes as well as for meeting
unanticipated expenses. Hence, the companies have to borrow from the market, well
established and large firms have better access to the capital market than new and small,
firms and hence, they can pay higher rate of dividend. The new companies generally find
it difficult to borrow from the market and hence they cannot afford to pay higher rate of
dividend.
8. Growth Needs of the Company:
Another factor which influences the rate of dividend is the growth needs of the
company. In case the company has already expanded considerably, it does not require
funds for further expansions. On the other hand, if the company has expansion
programmes, it would need more money for growth and development. Thus when
money for expansion is not, needed, then it is easy for the company to declare higher
rate of dividend.
9. Profit Rate:
Another important consideration for deciding the dividend is the profit rate of the firm.
The internal profitability rate of the firm provides a basis for comparing the productivity
of retained earnings to the alternative return which could be earned elsewhere. Thus,
alternative investment opportunities also play an important role in dividend decisions.
10. Legal Requirements:
While declaring dividend, the board of directors will have to consider the legal
restriction. The Indian Companies Act, 1956, prescribes certain guidelines in respect of
declaration and payment of dividends and they are to be strictly observed by the
company for declaring dividends.
11. Policy of Control:
Policy of control is another important factor which influences dividend policy. If the
company feels that no new shareholders should be added, then it will have to pay less
dividends. Generally, it is felt, that new shareholders, can dilute the existing control of
the management over the concern. Hence, if maintenance of existing control is an
important consideration, the rate of dividend may be lower so that the company can
meet its financial requirements from its retained earnings without issuing additional
shares to the public.
12. Corporate Taxation Policy:
Corporate taxes affect the rate of dividends of the concern. High rates of taxation reduce
the residual profits available for distribution to shareholders. Hence, the rate of
dividend is affected. Further, in some circumstances, government puts dividend tax on
distribution of dividends beyond a certain limit. This may also affect rate of dividend of
the concern.
13. Tax Position of Shareholders:
The tax position of shareholders is another influencing factor on dividend decisions. In a
company if a large number of shareholders have already high income from other sources
and are bracketed in high income structure, they will not be interested in high dividends
because the large part of the dividend income will go away by way of income tax. Hence,
they prefer capital gains to cash gains, i.e., dividend capital gains here we mean capital
benefit derived by the capitalisation of the reserves or issue of bonus shares.
Instead of receiving the dividend in the form of cash (whatever may be the per cent), the
shareholders would like to get shares and increase their holding in the form of shares.
This has certain benefits to shareholders. They get money by selling these extra shares
received in proportion to their original shareholding.
This will be a capital gain for them. Of course, they have to pay tax on capital gains. But
the capital gains tax will be less compared to the income-tax that they should have paid
when cash dividend was declared and added to the personal income of the shareholders.
14. Effect of Trade Cycle:
Trade cycle also influences the dividend policy of the concern. For example, during the
period of inflation, funds generated from depreciation may not be adequate to replace
the assets. Consequently there is a need for retained earnings in order to preserve the
earning power of the firm.
15. Attitude of the Interested Group:
A concern may have certain group of interested and powerful shareholders. These
people have certain attitude towards payment of dividend and have a definite say in
policy formulation regarding dividend payments. If they are not interested in higher rate
of dividend, shareholders are not likely to get that. On the other hand, if they are
interested in higher rate of dividend, they will manage to make company declare higher
rate of dividend even in the face of many odds.
16. Nature of Earnings:
The nature of business has an important bearing on the dividend policy. The industrial
units that are having stability of earnings may formulate (adopt) stable or a more
consistent dividend policy than other that are having variations in earnings, because
they can predict easily their earnings.
Firms that are involved in necessities suffer less from stable incomes than the firms that
are involved in luxury goods. The industries/firms that are having stable earnings can
adopt stable or high dividend policy, while the other firms that are having variations in
earnings should follow a variable or low dividend policy.
17. Age of Company:
The age of company has more impact on distribution of profits as dividends. A newly
started and growing company may require much of its earnings for financing expansion
programs or growth requirements and it may follow rigid dividend policy, wherein most
of the earnings are retained.
On the other hand, an old company with good track record and good name in the public
can formulate a clear cut and more consistent dividend policy. This type of companies
may even pay 100 per cent dividend payout ratio and the required amount for growth
can be raised from public.
TRADITIONAL PROPOSITION VS MILLER AND MODIGLIANI THEORY ON
DIVIDEND POLICY
Definition: According to Miller and Modigliani Hypothesis or MM Approach,
dividend policy has no effect on the price of the shares of the firm and believes that
it is the investment policy that increases the firm’s share value.

The investors are satisfied with the firm’s retained earnings as long as the returns
are more than the equity capitalization rate “Ke”. What is an equity
capitalization rate? The rate at which the earnings, dividends or cash flows are
converted into equity or value of the firm. If the returns are less than “Ke” then, the
shareholders would like to receive the earnings in the form of dividends.

Miller and Modigliani have given the proof of their argument, that dividends
have no effect on the firm’s share price, in the form of a set of equations, which
are explained in the content below:

Proof of Miller and Modigliani Hypothesis

 Assumptions of Miller and Modigliani Hypothesis

1. There is a perfect capital market, i.e. investors are rational and have access to all
the information free of cost. There are no floatation or transaction costs, no
investor is large enough to influence the market price, and the securities are
infinitely divisible.
2. There are no taxes. Both the dividends and the capital gains are taxed at the similar
rate.
3. It is assumed that a company follows a constant investment policy. This implies
that there is no change in the business risk position and the rate of return on the
investments in new projects.
4. There is no uncertainty about the future profits, all the investors are certain
about the future investments, dividends and the profits of the firm, as there is no
risk involved.

Criticism of Miller and Modigliani Hypothesis

1. It is assumed that a perfect capital market exists, which implies no taxes, no

flotation, and the transaction costs are there, but, however, these are untenable in
the real life situations.
2. The Floatation cost is incurred when the capital is raised from the market and thus
cannot be ignored since the underwriting commission, brokerage and other costs
have to be paid.
3. The transaction cost is incurred when the investors sell their securities. It is
believed that in case no dividends are paid; the investors can sell their securities to
realize cash. But however, there is a cost involved in making the sale of securities,
i.e. the investors in the desire of current income has to sell a higher number of
shares.
4. There are taxes imposed on the dividend and the capital gains. However, the tax
paid on the dividend is high as compared to the tax paid on capital gains. The tax
on capital gains is a deferred tax, paid only when the shares are sold.
5. The assumption of certain future profits is uncertain. The future is full of
uncertainties, and the dividend policy does get affected by the economic
conditions.

Thus, the MM Approach posits that the shareholders are indifferent between the
dividends and the capital gains, i.e., the increased value of capital assets.

Criticism of M-M Hypothesis:

It has already been stated in earlier paragraphs that M-M hypothesis is actually
based on some assumptions. Under these assumptions, no doubt, the conclusion
which is derived is logically sound and consistent although they are not well-based.

For instance, the assumption of perfect capital market does not usually hold good
in many countries. Since the assumptions are unrealistic in nature in real world
situation, it lacks practical relevance which indicates that internal and external
financing are not equivalent.

The shareholders/investors cannot be indifferent between dividends and capital

gains as dividend policy itself affects their perceptions, which, in other words,
proves that dividend policy is relevant.

As a result, M-M hypothesis, is criticized on the following grounds:

(i) Tax Differential:

M-M hypothesis assumes that taxes do not exist, in reality, it is impossible. On the
contrary, the shareholders have to pay taxes on the dividend so received or on
capital gains. We know that different tax rates are applicable to dividend and
capital gains and tax rate on capital gains is comparatively low than the tax rate on
dividend.

That is why, an investor should prefer the capital gains as against the dividend due
to the fact that capital gains tax is comparatively less and such capital gains tax is
payable only when the shares are actually sold in the market at a profit.

In short, the cost of internal financing is cheaper as compared to cost of external

financing. Thus, on account of tax advantages/differential, an investor will prefer a
dividend policy with retention of earnings as compared to cash dividend.

(ii) Existence of Floatation Costs:

M-M also assumes that both internal and external financing are equivalent. It
indicates that if dividend is paid in cash, a firm is to raise external funds for its own
investment opportunities. There will not be any difference in shareholders’ wealth
whether the firm retains its earnings or issues fresh shares provided there will not
be any floatation cost.
But, in reality, floatation cost exists for issuing fresh shares, and there is no such
cost if earnings are retained. As a result of the floatation cost, the external
financing becomes costlier than internal financing. Therefore, if floatation costs are
considered external and internal financing, i.e., fresh issue and retained earnings
will never be equivalent.

(iii) Existence of Transaction Costs:

M-M also assumes that whether the dividends are paid or not, the shareholders”
wealth will be the same. When the dividends are not paid in cash to the
shareholder, he may desire current income and are as such, he can sell his shares.

When a shareholder sells his shares for the desire of his current income, there
remain the transaction costs which are not considered by M-M. Because, at the
time of sale, a shareholder must have to incur some expenses by way of brokerage,
commission, etc., which is again more for small sales. A shareholder will prefer
dividends to capital gains in order to avoid the said difficulties and inconvenience.

(iv) Diversification:
M-M considers that the discount rate should be the same whether a firm uses
internal or external financing. But, practically, it does not so happen. If the share-
holders desire to diversify their portfolios they would like to distribute earnings
which they may be able to invest in such dividends in other firms.

In such a case, shareholders/investors will be inclined to have a higher value of

discount rate if internal financing is being used and vice-versa.

(v) Uncertainty:
According to M-M hypothesis, dividend policy of a firm will be irrelevant even if
uncertainty is considered. M-M reveal that if the two firms have identical invest-
ment policies, business risks and expected future earnings, the market price of the
two firms will be the same. This view is actually not accepted by some other
authorities.

According to them, under conditions of uncertainty, dividends are relevant

because, investors are risk-averters and as such, they prefer near dividends than
future dividends since future dividends are discounted at a higher rate as dividends
involve uncertainty. Thus, the value of the firm will be higher if dividend is paid
earlier than when the firm follows a retention policy.