MM hypothesis

Topics: Dividend, Cost, Economics Pages: 5 (1460 words) Published: February 25, 2014
MM Hypothesis – A Critique
The assumptions of MM hypothesis are unrealistic and untenable in practice. As a result, the conclusions that dividend payment and other methods of financing exactly offset each other and hence, the irrelevance of dividends, is not a practical proposition; it is of merely theoretical relevance. The validity of MM approach is open to question on two counts: 1.Imperfection of Capital market

2.Resolution of uncertainty
Market Imperfection
MM assume that capital markets are perfect. This implies that there are no Taxes; flotation costs do not exist and there is absence of transaction costs. These assumptions are untenable in real world situation. Tax Effect

An assumption of the MM hypothesis is that there are no Taxes. It implies that retention of earnings (internal financing) and payment of dividends (external financing) are, from the viewpoint of tax treatment, on an equal footing. But the assumption of absence of taxes is unrealistic as the income of the investors, with few exceptions, is liable to tax. Small investors do not pay tax on dividend income because such is tax free up to a specified amount. The tax liability of the investors, broadly speaking is of two types: 1)Tax on dividend income and

2)Capital gains
From the operational view point, capital gains tax is i) lower than the tax on dividend income and ii) it becomes payable only when shares are actually sold, i.e it is a deferred tax till actual sale of the shares. There is a definite advantage to the investors owing to the tax differential in dividend and capital gains tax and, therefore, they can be expected to prefer retention of earnings. Elton and Gruber have shown that investors in high income brackets have a preference for capital gains over dividends while those in low tax brackets favour dividends. In brief, the investors are not, from the view point of taxes, indifferent between dividends and retained earnings. The MM hypothesis is, therefore, untenable. Flotation Costs:

Another assumption is the absence of flotation costs. The term flotation costs refers to the cost involved in raising capital from the market e.g. underwriting commission, brokerage, road show and other expenses. The presence of flotation costs affects the balancing nature of internal (retained earnings) and external (dividend payments) financing. External financing through sale of shares would be costlier than internal financing via retained earnings. Transaction and Inconvenience Costs:

Another assumption which is open to question is that there are no Transaction Cost in the Capital Market. Transaction costs refer to costs associated with the sale of securities by the share holders – investors. The no transaction cost postulates implies that if dividends are not paid (or earnings are retained) the investors desirous of current income to meet consumption needs can sell a part of their holdings without incurring any cost, like brokerage and so on. This is obviously an unrealistic assumption. Apart from the Transaction costs, the sale of securities, as an alternative to current income, is inconvenient to the investors. Moreover, uncertainty is associated with the sale of securities. Institutional Restriction:

SEBI Guideline: The dividend alternative is also supported by legal restrictions as to the type of ordinary shares in which certain institutional investors can invest. For instance, LICI is permitted in terms of clause 1 (a) to 1 (g) of Section 27 – A of the Insurance Act, 1938 to invest only such equity share on which a dividend of not less than 4% including Bonus has been paid for 5 years or for at least 5 years out of 7 years immediately preceding. To be eligible for institutional investment the company’s should pay dividends. These legal impediments, therefore, favour dividends to retention of earnings. To conclude the discussion on market imperfections, there are four factors which dilute the indifference of investors between dividends...
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