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How do Transaction Costs affect the Dividend Policy of a company?
One of the assumptions of the Modigliani-Miller model is that the internal financing (retained earnings) and the external financing (issue of new shares) are equivalent in nature. Therefore, when a company wants to raise funds, it can issue new shares to get the required funds. It is assumed that this issuance of new shares is free of cost for the shareholders. The issuance of shares does not impact the wealth of shareholders, as the transaction is free of cost. However, in practice, this is just the reverse of the process that takes place in a real-world market.
What are Transaction Costs?
The issuance of new shares in the market involves transaction costs, which is also known as floatation costs or issue costs. As the name suggests, it involves the costs associated with floating or issuance of shares. It includes the expenses such as broker's fee, costs in making and issuing the prospectus, and underwriting.
Transaction costs can be huge for companies that have a large shareholding pattern, but for small firms and small investors, it may not be significant.
The existence of transaction or flotation costs make external financing costlier than the internal financing. It is so because internal financing being funded by retained earnings. As the retained earnings are used to fund the internal financing, the costs of earnings from dividends is out of focus in the MM model.
How Do Transaction Costs Affect the Dividend Policy?
Retained earnings is favored over payment of dividends because the equivalence between the new share capital and retained earnings is affected. Companies usually continue paying the same dividends over time. The dividend policy of a company is normally sticky in nature. Therefore, transaction costs play a key role in devising the capital policy of the dividend payout by the firms.
Under the MM hypothesis, the wealth of the shareholder remains intact irrespective of whether dividends are paid or not. The shareholder can sell her shares in the market if she desires to get funds without having to wait for dividend payout. However, this is easier said than done. A shareholder will have to incur a cost while selling the shares in the market, as she has to pay the brokerage while doing so. The brokerage is not so significant when the number of shares is less. However, it can impact the shareholders having a large portfolio.
There are other issues associated with transaction costs as well. For example, some emerging or fresh markets are not liquid enough, posing great challenges for the small shareholders to sell their shares whenever they wish. Transaction cost, therefore, is an impactful factor in shareholding and dividend policy.
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