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What are Miller and Modigliani's arguments against uncertainty regarding Current Vs Future Dividends?
The Miller Modigliani model of dividend evaluation is one of the most influential theories in finance. It shows the relation of dividend payout and shareholder’s preferences in a new light. It asserts that shareholders prefer current payout over capital gains for a host of reasons. The most powerful among the reasons are the risks involved in the market and diversification of portfolios for which the MM model becomes more relevant.
The MM model, however, does not offer a reason for difference in payout in present or future due to similar current and future dividend payouts. The MM model assumes that the current and future payments in a perfect market are equal and there is no difference between the present and future uncertainty. Therefore, there is no risk in holding shares of a firm for indefinite periods without losing any value in the process.
According to the MM model, there is no value in the status of companies that offer no dividends Vs the ones that pay dividends. However, in practice, the companies that offer current dividends are considered superior by the shareholders. The current payout being of more value than the future one, shareholders in the real world prefer the current dividend paying firms rather than the ones that offer capital gains.
The Uncertainty Argument
Miller and Modigliani's model cancels the uncertainty argument.
It assumes that even if there is a potential benefit in getting current payouts rather than capital gains, there is no effect of no dividend payouts in the process of evaluation of a firm by investors.
The MM model argues that since the firms having similar capital structure and investment have similar dividend policies, there is no net effect of paying out dividends or holding it for future by the firms.
A Flawed Model
The MM model of dividend policy is flawed in nature.
There is hardly any firm that has dividend yield or retention that makes no difference in the shareholder’s value.
In practice, retaining the earnings and paying dividends are two factors that impact the bottom-line of the companies strongly.
The shareholders usually prefer dividend paying firms more than the firms that retain all of the earnings.
The MM model suggests that there is no net effect of dividend payout by the companies in their financial statuses. This assumption that dividend payout has no effect on financials of a company is null and void in the real world. So, the MM model fails to justify its stand and is not applicable fully to real world situations.
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