MM hypothesis
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,
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,