Corporate financial management - Essay Example

Investors are attracted to invest in a stock depending on the company’s dividend policy, which is defined as “the proportion of after tax earnings paid out in cash to the shareholders by a company” (lecture notes). Several theories have been formulated that seek to explain how investors are affected by dividends and the value of their equity holdings. From the point of view of the investor, unnecessary risk may be averted if it became possible to forecast the future price directions of stocks.

This is the rationale behind dividend theory, that supposedly dividends have informative content that convey to investors the value of the company, and would tend to influence investor attitude towards the stock. The traditional view stated that use of debt lowers the cost of capital. With a lower cost of capital as discount rate, assuming the cash flows unchanged, then the value of the firm becomes higher. However, the problem with the traditional view is that it ignores the increased risk of gearing to equity holders, thereby increasing cost of equity (lecture notes).

According to Modigliani and Miller’s trade-off theory, firms should favour the use of debt. M&M theory showed that the higher the debt capital used by the firm, the higher the value of the firm, even to the point of maximizing value at 100% debt. M&M, however, states that capital structure or gearing (the amount of debt) does not affect the weighted average cost of capital, and therefore the value of the firm. The M&M theory assumes, however, very restrictive and unrealistic assumptions, ignoring entirely the cost of debt default and bankruptcy.

Allowing for cost of bankruptcy, a point is reached where the benefit of the tax deductibility of interest on the debt is offset by increase in the costs of debt and of equity as a result of the risk due to high leverage (USF, 2010). Miller and Modigliani (1961) theorized that in a perfect market, a firm’s investors