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Corporate Financial Policy

Based on your readings in this unit and your own research, respond to the following:

What are the various elements of corporate financial policy?
How do different types of investors react to the various elements of corporate financial policy?
What is meant by signaling in dividend policy?
How do different types of investors react to dividend policy signals?

MIKE DEMPSEY

The Modigliani and Miller Propositions:
The History of a Failed Foundation

for Corporate Finance?

The Modigliani and Miller (MM) propositions provide a foundation for
corporate finance theory. Nevertheless, this paper argues that their adop-
tion has led to a disengagement of such theory from the humanity of
business, as well as, more broadly, from concepts of corporate strategic
management. As a result, the context within which textbooks allow corpo-
rate investment and financial decisions to take place is severely distorted
from reality. The paper argues that we require the context of behavioural
and strategic corporate management if we are to accommodate the reality
of business, the behaviour of formalised groups, and an ethical dimension
to business.

Key words: Capital structure; Corporate finance; Dividends; Investments;
Modigliani and Miller propositions.

This paper argues that the focus on the Modigliani and Miller (MM) propositions as
the foundation of corporate management has led to a stylized representation of
corporate financial decision making that is far removed from reality. Specifically, it
has brought about a disengagement from the behavioural and corporate strategic
contexts within which corporate financial decision making actually functions.

It is not, I note, a case of whether the MM propositions are ‘right’ or ‘wrong’. It is,
for example, possible to build a working model of the solar system with the Earth at
the centre (such a model existed at the time of Copernicus) but this model has
distorted what is actually central and therefore cannot be extended to understanding
the universe outside the solar system. The model is more or less exhausted. Similarly,
with MM theory, the problem is that experiences are not actually illuminated by the
model’s core assumptions, but by postulating contradictions to those assumptions.
The model ‘can go no further’. The broader galaxy of strategic corporate manage-
ment, the elements of reputation and trust underlying corporate and financial activ-
ity, and recognition of an ethical dimension to behaviour are outside its domain.

Mike Dempsey (michael.dempsey@rmit.edu.au) is a Professor in the School of Economics, Finance and
Marketing, RMIT University, Melbourne, Australia.
The author wishes to show his appreciation for conversations with Professors Kevin Keasey, Robert
Hudson, Graham Partington and Imad Moosa, which have motivated this essay.

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In the aftermath of the global financial crisis (GFC), we have become more aware
of the limitations of MM theory. My purpose in the present paper is to argue that we
require not so much continued adjustments to the MM basis of financial theory but,
rather, an acknowledgement of the fact that financial challenges cannot always be
resolved with more sophisticated mathematics of rational behaviour. Progress
requires that we recognize the social science nature of corporate decision making
not as an add-on, but as central to an understanding of how formalized groups of
people with responsibilities for outcomes actually make decisions.

DISSENTING VOICES

A concern with the widening gap between academic research and finance as a
practitioner activity is articulated by Keasey and Hudson (2007).1 These authors
contend that, rather than continue to build elaborate theoretical models with limited
success to explain the actions of financial advisers, finance academics should leave
their offices and go and talk with them. The ability to speak with the objects of one’s
study is, after all, the advantage of a social science over the pure sciences. The
authors argue that academic teaching and research within finance must bridge the
gap with actual financial activities and take account of the interactions of individual
investors, institutional investors, financial intermediaries, companies, and the market
itself if the subject area is not to become moribund. Keasey and Hudson (2007,
p. 947) state,

The real question which this paper gives rise to is how finance as a subject is going to
progress. In the context of ‘traditional’ finance the research community, unfortunately,
tends to act as though all important insights are already contained within the existing core
of financial theory. All that remains is a protracted tidying up process whereby any remain-
ing anomalies or puzzles are somehow reconciled with the existing core theory no matter
how complex and unlikely are the manoeuvres necessary to do this . . . One way forward
will be to actively engage with each of a set of participants and try to understand their
beliefs and actions. Once the participant sets are better understood in their own terms, then
interactions between them can be explored from a sound base.

McSweeney (2009) emphasizes that academia has embedded the perception that
financial markets are efficient and self-correcting. This agrees with economists
Akerlof and Shiller (2009), who argue that we have been deceived by a theory that
said nothing dangerous could happen. For these authors, the weakness of the theo-
ries of market behaviour is that they ignore the role of ‘animal spirits’. Furthermore,
the possibility that financial activities are often highly imperfect and that financial

1 Keasey and Hudson’s (2007) critique follows an altogether too thin line of financial criticism from
financial academics, including Whitley (1984, 1986), McGoun (1995), Dempsey (1996), and Hudson
et al. (1999). More recently, critiques of financial markets have been forthcoming from economists and
financial observers, including Partnoy (2004), Das (2006), Froud et al. (2006), McKenzie (2006, 2009),
Fine and Milonakis (2009), Fox (2009), McSweeney (2009), and in a special issue of this journal, from
Cai et al. (2013), Dempsey (2013a, b), and Moosa (2013), but with counter support for asset pricing
theory from Benson and Faff (2013), Berkman (2013), Bornholt (2013), Brown and Walter (2013),
Partington (2013), Smith and Walsh. (2013), and Subrahmanyam (2013).

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markets are unstable and evolving is eschewed; instead, there is denial that
either government, regulators, or even shareholders should interfere in the market’s
operations, to warn against excesses (leveraged speculation at the levels of the
corporate and financial sectors), call for stronger balance sheets for banks, or curtail
executive pay. Shiller (2010) quotes Paul Krugman as stating that the professions
went astray because they mistook beauty, clad in impressive-looking mathematics,
for truth.

The feeling that academic finance has become stultified in its adherence to the
core physics of its underlying principles is voiced by Lo and Mueller (2010), who
observe that, only a few decades ago, any challenge to the notion of market efficiency
was anathema and that papers claiming to have discovered departures in the data
from what was predicted by the capital asset pricing model (CAPM) were ‘routinely
rejected from the top economics and finance journals, in some cases, without even
being sent out to referees for review’ (p. 18). In the introduction to their paper, the
authors explain,

The quantitative aspirations of economists and financial analysts have for years been based
on the belief that it should be possible to build models of economic systems—and financial
markets in particular—that are as predictive as those in physics (p. 13).

As a reaction to the GFC, Hopwood (2009) warns of the growing distance of the
academic finance base from the complexities of practice and practical institutions.
The author considers that academics often have a very limited understanding of
finance in practice and that their teaching lacks appropriate consideration for the
wider consequences of financial practice: ‘Not only has a great deal of finance
research become focused on more abstract considerations but it also is as if a
diversity of research perspectives and traditions cannot be tolerated’ (p. 549). For
such as Hopwood, the idea of finance as a ‘history’ of events, a social science calling
on students to consider, discuss, and formulate essays in defence of their view
point—while recognizing that financial history never exactly repeats itself—has
given way to the expectation that students be able to demonstrate an understanding
of facts and competences in idealized computational problems.

CORPORATE FINANCE AND THE PARADIGM OF THE
MM PROPOSITIONS

By the late 1950s, the writings of Karl Popper had done much to exalt the philo-
sophical basis of science as the rational process, progressing towards objective truth
on the basis of the falsification method of theory selection. At that time, too, the high
prestige of the natural sciences encouraged the belief that the modelling of decision
making and resource allocation problems could be identified with the elaboration of
optimization models and the general extension of techniques from applied math-
ematics. In a scientific world, the logical structure of decision making implied that
practising managers were likely to make more optimal decisions when supplied with
a richer set of positive theories that provided a better understanding of the conse-
quences of their choices. It was natural, therefore, that finance theory (along with
other social science disciplines) should seek to identify with the scientific method.

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It was into this environment in the late 1950s that MM ushered in their agenda for
the modern theory of corporate finance. The objective of the firm was to maximize
the wealth of shareholders (as owners of the firm). Thus, the ‘value’ of the firm was
its price in the marketplace. The discipline was thereby transformed from an insti-
tutional normative literature—motivated by and concerned with topics of direct
practitioner relevance, such as the operations of financial institutions and proce-
dures for raising long-term finance—into a microeconomic positive science centred
around corporate policy decisions and addressing questions such as what are the
effects of alternative investment, financing, and dividend policies on a firm’s share
price? In this way, corporate financial decision making was formulated as an appli-
cation of economic asset valuation models with reference to perfect capital markets
(e.g., Fama, 1976, Ch. 5). The idea that corporate financial decision making is inte-
grated with ‘management’ in ensuring that the firm can survive and grow—while
leaving it to financial markets to offer fair prices to investors—was denied. The
outcome is that theories of corporate financial behaviour and of investment finance,
such as portfolio investment theory, must be integrated as two sides of the same
investment coin.

At the same time as the basic conceptual models of efficient capital markets
were being tested against databases of historical capital market price movements,
the theoretical implications of the models for business financial decision making
were being clarified. It followed that the firm’s key financial decision making nodes,
that is, (i) where the firm should be making financial investments (the investment
decision), (ii) how the firm should be financing those investments, given available
sources of investment finance (the capital structure decision), and (iii) at what
point the firm should be returning the fruits of those investments to investors (the
dividend decision), must be understood on the basis of providing the firm’s inves-
tors with a rate of financial return that at least matches their comparable oppor-
tunities elsewhere. In other words, investors’ required expectation of financial
return represents a firm’s cost of financial capital, on the basis of which all financial
decisions are assessed.

The logical outcome was that firms were exhorted to justify their investment
decisions on the basis of the net present value (NPV) of their expected cash flows,
discounted by a cost of capital calculated from the CAPM. Notwithstanding the
reluctance of practitioners to be in accord with a literal interpretation of the NPV
investment criterion, researchers in management accounting and finance by the
mid-1970s were generally won over by a belief in its efficacy. A great deal of
activity developed around surveying and documenting the extent to which capital
budgeting decision makers used, or did not use, various techniques for analysing
potential investments. The implication was always that the use of NPV revealed
sophistication, whereas the use of methods such as payback and accounting rates
of return revealed either ignorance of better methods or irrationality in refusing
to adopt better methods. Miller (of MM) (1977) questioned why ‘the pay-back
criterion continues to thrive despite having been denounced as Neanderthal
in virtually every textbook in finance and accounting over the last 30 years?’
(p. 274).

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Leading from the paradigm of the cost of financial capital, the market value of a
firm was pronounced independent of both the firm’s capital structure and its divi-
dend policy and the financial objective of management was reduced to identifying
those investment opportunities the expected cash flows of which, discounted by the
market opportunity cost of investment capital employed, produce a positive NPV
(Modigliani and Miller, 1958). When corporate and personal taxes were introduced,
it was suggested that firms should never pay dividends and strive to have 100% debt
in their capital structures (Modigliani and Miller, 1963; Farrar and Selwyn, 1967;
Brennan, 1970). Individuals within the corporation are ignored at this stage, either
by assuming that they act as well-trained robots (as in the investment decision) or by
paralysing them with the ceteris paribus assumptions that underlie the classical
capital structure propositions (Brennan, 1995). Similarly, individuals with whom a
corporation must deal—investors, banker, underwriters, bidders, customers, employ-
ees, and others—were rendered essentially uninteresting, by treating them as price
takers.

In response to the unrealistic corner point solutions generated from such
assumptions, the early leading candidates for the study of departures from the MM
conditions were bankruptcy costs, financial ‘distress’, transaction costs, and ‘signal-
ling’ theory. An explosion of models based on agency theory—with information
asymmetry, the nature of implicit and explicit contracts, as well as non-pecuniary
considerations, such as reputation and effort aversion—has been motivated by the
need to attain reconciliation between the directives of theory and observed prac-
tice. Nevertheless, contributions that acknowledge institutional/behavioural dimen-
sions are expected to confront the paradigm of perfect markets and present
arguments in the language of its terms of reference. As Ross recognizes in a 1988
review of the MM propositions that ‘economists now do look at finance through
the eyes of MM’ (p. 133), thereby supporting Weston (1989) and Miller’s (1988)
contention (in his own review chapter of the MM propositions) that ‘showing what
doesn’t matter can also show, by implication, what does’ (p. 100). Or, again, as
Stiglitz (1988) puts it,

Some of the most productive responses to the MM results have come from those who did
not feel able to accept the conclusion that financial policy is irrelevant. The MM results
force those sceptics to identify which of the assumptions underlying the MM theorem
should be modified or rejected (p. 122).

Thus we observe that reconciliation of observed practice with theoretical models
continues to be pursued within an MM/cost of capital framework, where mathemati-
cal coherence and integrity are a condition for contribution. It may be deemed that
a stream of literature has thereby been successfully generated, as a result of which
the understanding of corporate financial behaviour has been hugely stimulated and
consequently greatly sharpened from both theoretical and empirical perspectives. A
glance at such as the Journal of Corporate Finance or the Journal of Finance reveals
the striking departure that has taken place from everyday language as a medium in
which to develop concepts and ideas to that of the mathematically skilled and the
academically rigorous and abstract.

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CORPORATE MANAGEMENT AND STRATEGY

Prior to the MM propositions, textbook writers’ recommendations and prescriptions
on corporate finance were formulated as a distillation of experience interpreted
by the writer. The major corporate finance textbook prior to the late 1950s was
published by Dewing (1919), who advanced principles of judgment for a firm’s
investment, financing, and dividend policies on the basis of his observations and
experiences over a career covering a wide range of firms.2 Dewing’s argument was
that the firm’s most fundamental investment decision is that of determining whether
economic circumstances call for either the firm’s expansion or contraction. As simple
as the concept may appear, Dewing regarded the enactment of the principle as the
essential determinant of a firm’s success or failure—as well as being the decision that
most called on management acumen and entrepreneurial skill. He considered that
the production of a firm was a direct result of a relatively constant factor in the form
of fixed capital investment and a variable factor in the form of human labour, the
whole administered by an intangible economic value called entrepreneurial ability.
The firm is in equilibrium when its investment strategy is at the point of decreasing
returns with expansion.

Dewing’s text progresses to discuss the financial problems incident to obtaining
financing for extensions, with special reference to sources of new capital. Neverthe-
less, Dewing’s understanding of entrepreneurial activity is never divorced from an
understanding of what he terms the humanity of business. His text emphasizes
repeatedly that motives other than economic are at play: ‘The impelling springs of
human action are difficult to fathom’. For Dewing, business managers retain their
human attributes and their solutions of the difficult problems of business expansion
often cannot be readily forecast in accordance with economic tenets.3

2 In the MM world, the intuitive normative approach contributions of the early writers could be ignored.
Brennan (1995, p. 11), for example, singles out Dewing’s contribution as, ‘detailed institutional fussi-
ness’ and Smith’s (1990, p. 3) The Theory of Corporate Finance: a Historical Overview singles out
Dewing for dismissal while requiring only a single paragraph to account for corporate finance theory
prior to the late 1950s:

The finance literature through the early 1950s consisted in large part of ad hoc theories and
institutional detail, but little systematic analysis. For example, Dewing (1919, 1953), the major
corporate finance textbook for generations, describes the birth of a corporation and follows it
through various policy decisions to its death (bankruptcy). Corporate financial theory prior to the
1950s was riddled with logical inconsistencies and was almost totally prescriptive, that is, norma-
tively orientated. The major concerns of the field were optimal investment, financing, and dividend
policies, but little consideration was given to the effects of individual incentives, or to the nature of
equilibrium in financial markets.

3 Dewing (1919, Vol. 4, p. 4) established the tone of his study of corporate investment decision making
with the opening passage to his text:

Four main motives have led men to expand business enterprises. On the whole they are not
economic, but rather psychological; they are the motives incident to the struggle for conquest and
achievement—the precious legacy of man’s ‘predatory barbarism’. Primarily a man measures the
success of a business by increased size, and secondarily by increased profits . . . The race-old instinct
of conquest becomes translated in our twentieth century economic world into the prosaic terms of

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The development of frameworks within which the decisions of firms as organi-
zations might be understood has continued. Such development, however, is con-
strained within what we term management literature, which is effectively divorced
from finance. Since early years, management authors have emphasized a world
in which managers face overwhelming complexity: decision problems are poten-
tially ‘messy’ (Ackoff, 1970), ‘ill-structured’ (Mintzberg et al., 1976; Mitroff and
Emshoff, 1979), with ‘wicked problems of organized complexity’ (Mason and
Mitroff, 1981, p. 12; Duhaime and Thomas, 1983). The outcome is that problems
of investment and financing as encountered by the firm are characterized by
challenges of complexity, interconnectedness, uncertainty, ambiguity, conflict, and
societal constraints.

Consequently, management authors have stressed that organizations experience
tremendous difficulty in responding to change (Starbuck and Hedberg, 1977;
Pettigrew, 1985) and that structural and political factors create additional inertia
(Mintzberg, 1978; Miller and Friesen, 1980, 1984; Pettigrew, 1985). Dent (1990)
considers that this may be explained by the fact that organizations have been
selected more or less deterministically to their distinct niches in the first place, on
the basis that their particular capabilities are valued. From this perspective, we
must be careful even as to the extent to which an organization has volition in its
choices (Astley and Van de Ven, 1983). Certainly the capabilities of firms are
defined by sunk costs, irreversible investments, and the characteristics of its per-
sonnel built up in the past, so that the organization’s strategies are determined by
where they have been in the past and by what they have done. Investment deci-
sions that are directed at realigning a firm’s competitive posture in terms of new
competitive strengths and distinctive competences are the exception (Pfeffer and
Salancik, 1978).

Management authors have sought to clarify how, within a paradigm of overarching
strategy, a firm’s everyday tactical and implementing activities take place over a
range of departments, with engineering, marketing, and production departments
responsible for crucial investment decisions (Petty et al., 1975; Ross, 1986;
Mukherjee and Henderson, 1987). In this world, although investment proposals
must be screened for their strategic fit with a firm, both personal and political
reasons (prestige, personal/departmental ambition, empire building) also underlie a
project idea’s initial proposal. Thereafter, an individual wishing to carry a new idea
through will doubtlessly need the support of others. Negative reactions are part of

corporate growth. Business expansion is the spirit of a modern Tamerlane seeking new markets to
conquer. It is a pawn for human ambition. The second motive, less significant, one is led to believe,
is the creative impulse . . . It is a commonplace of psychology that somewhere in the mental
structure of all of us lies the impulse to build, to see our ideas take form in material results . . . The
third motive is the economic. My own observation is that the vast majority of businessmen who plan
enlargements, consolidations, and extensions of their business are not actuated primarily by the
impulse to make more money, although they unquestionably place this motive uppermost when
they need to present plans for enlargement to directors and stockholders . . . And it appears
foremost in every business manager’s mind when he attempts to justify a business policy which may
have been in the first instance subconsciously prompted by less obvious and more basal motives. . . .
The fourth motive is the satisfaction in taking speculative chances . . . All men enjoy the game they
think they can play.

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the appraisal process and, for this reason, a new project idea may require a sponsor
with reputation who is prepared to back the project and be identified with it (Bower,
1970, p. 77; Hopwood, 1974, p. 134; King, 1975). Reputation based on past perfor-
mance and lobbying and exhortations have a part to play as commitment and trust
relationships are engendered. Ultimately, the bottom–up development of division
plans and top-down portfolio management must come together in the approval of
division plans and budgets. At this stage, ultimate endorsement of an investment
proposal is likely viewed as an endorsement of the proposer(s) or as a reflection on
the track record, prestige, and/or political influence of the proposer(s)/department
(e.g., Ross, 1986; Mukherjee and Henderson, 1987). Dempsey (1996) considers the
role that managerial credibility has to play in capital investment appraisal by quoting
one financial director:

If you get a project and do it well, then you go onto the next one. And then you’ll be given
more opportunity. If you don’t, then you’re going to be on the wayside. People are pretty
careful. It happens on a human level almost more than on a numbers level. The whole
process of who gets selected to do what comes out of people having watched what various
people are doing.

Dempsey also references McAulay (1996), who observes that the issue of credibility
in management is generally under researched.

From this perspective, managers at tactical and routine levels may more correctly
be viewed as implementers rather than as investment decision makers. We might
even think of managers as acting out the paradigm of the firm. In this view, a
manager’s job is to sense what constitutes a satisfactory level of performance, whose
ideas are worth listening to, and what events are significant predictors of future
opportunities and calamities. A successful decision maker depends more on an
ability to anticipate problems along with an ability to recognize a range of alterna-
tive courses of action than on an ability to carefully choose between them. Hence,
perhaps, the following managerial response to academic enquiry into their decision
making quoted by Dempsey (1996): ‘It’s a matter of applying judgement and
common sense. You guys overcomplicate these matters—it’s like I know when the
house needs painting!’

Carr et al. (1994) report that German managers view their U.S. and U.K. counter-
parts as spending too much time attempting to manipulate financial markets rather
than their product base. The German managers believe that a thorough knowledge
of the business and the perceived direction of markets, technologies, and competi-
tion are more important than financial manoeuvrings and do not believe that the
insights of business can be captured in NPV calculations. They consider that the sure
grasp of a business can take a lifetime to acquire and that this does not happen for
MBA executives who had been parachuted into the industry. Carr et al. (1994, p. 107)
quote one chief executive as follows:

Finance is not enough; it must be paired with intuition and intimacy with products, markets
and customers. US and UK managers sit too much in their offices over their figures . . .
When I talked of intuition it was not just out of the blue. Intuition is the very last thing when
you know everything. You have to have every kind of information about your competitors,
but the rest is intuition.

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The authors (p. 113) also cite another executive as stating, ‘When it is a success you
get a big explosion, and I believed in that explosion’.

From a rule of thumb of five years for payback, product line initiatives are now
often expected to redeem themselves within the first couple of years. The future
thereafter is likely to be so uncertain that all bets are off, which includes NPV
calculations. The heavy industries—the building of power stations, rail, the develop-
ment of oil fields—with a commitment to long investment horizons combined with
a level of predictability (that their outputs will be required many years from now)—
provide the best application of NPV. But even in these more stable, long-term
industries, it is unlikely that an NPV calculation actually drives the investment
decision and even more unlikely that the calculations make up the totality of the
decision making process. Strategic concerns that are subjective are voiced and
discussed and the ultimate decision typically represents the best consensus of varied
positions and even broadly divergent views.

From a management perspective, increasing shareholder wealth requires increas-
ing productivity and (real) earnings per share. This, in turn, requires working through
an understanding of the firm in its competitive environment and an unfolding
economy, with the intent of safeguarding and potentially expanding the firm’s
market position. The firm’s value resides in the complexity of managing and moti-
vating divisional performance and of identifying synergies between them. The imple-
mentation of such strategy, in turn, requires a sustained commitment to managing
the multiple challenges of product improvement, production management, costing,
budgeting, human resources, marketing, and strategy. The broader management
literature addresses these broader issues, which represent the context within which
financial corporate decision making actually takes place. Such complexities,
however, are conveniently ignored in the idealized model of the firm as identified by
academic corporate finance.

RECENT DEVELOPMENTS IN CORPORATE FINANCE

Shefrin (2001) observes that the traditional approach to corporate finance is
based on three concepts: (1) rational behaviour; (2) the CAPM; and (3) efficient
markets, but that (a) psychological phenomena prevent decision makers from
acting in a rational manner, (b) security risk premiums are not determined
by security betas, and (c) market prices are regularly at odds with fundamental
values. Thus, all three components of the traditional paradigm are effectively
undermined.

The outcome of such observations has been a body of corporate financial research
aimed at understanding the psychology of market participants, as financial managers
and investors. Much of the impetus for these studies derives from the cognitive
psychological experiments of Kahneman and Tversky (1979), as well as of Griffin
and Tversky (1992) and Kahneman and Lovallo (1993). For example, their experi-
ments show how anchoring occurs during normal decision making when individuals
overly rely on a specific piece of information to govern their thought processes. Once

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the anchor is set, there is a bias towards adjusting or interpreting other information
to reflect the ‘anchored’ information.4

In this work, the psychological attribute of overconfidence has provided a par-
ticular focus for investigation in academic finance. Shefrin (2001) makes the case for
overconfidence for both markets and firms.5 Such ‘psychology of the markets’ con-
nects with the body of evidence that challenges the traditional view that the collec-
tive actions of market participants in setting prices are always rational. In early
work, Daniel et al. (1998) advance a model of financial market distortions based on
investor overconfidence relating to information in combination with a bias to
confirm preconceived views when public information subsequently accords with
their bias (while remaining indifferent to information that challenges preconceived
views). The essence of this contribution is confirmed by Rabin and Schrag (1999),
who state that decision makers have a tendency to interpret new information as
confirmatory of prior beliefs and expectations.

The implications of overconfidence for specifically corporate financial decision
making have subsequently received a good deal of attention. Following Shefrin
(2001) are Gervais and Odean (2001, ‘Learning to be overconfident’), Heaton (2002,
‘Managerial optimism and corporate finance’), and Hilary and Menzly (2006, ‘Does
past success lead analysts to become overconfident?’). Heaton (2002), Malmendier
and Tate (2005a, 2005b, 2008), and Goel and Thakor (2008) focus on CEO overcon-
fidence and the implications for firm corporate investment decisions, while Doukas
and Petmezas (2007) (who find that overconfident mangers are liable to engage in a
run of ultimately unwise acquisitions) and Ferris et al. (2011) focus on CEO over-
confidence in relation to mergers and acquisitions.

The application of overconfidence to a firm’s financing arrangements (capital
structure) has been developed by Hackbarth (2008), while Ben-David et al. (2007)
develop a link between overconfidence and the firm’s dividend policy decisions, and
Hilary and Hsu (2011) apply overconfidence to examine managers’ ability to predict
earnings. The application of human psychology to shareholders’ assessment of divi-
dends has, of course, long been recognized in the literature, for example, the ‘bird in
the hand’ argument for dividends, where investors are more confident about imme-
diate dividends than future capital gains, has been rebuked by Miller and Modigliani
(1961). Shefrin and Statman (1984) and more recently Baker and Wurgler (2004)
have developed arguments for ‘dividend preference’ in the context of Kahneman
and Tversky’s (1979) prospect theory.

4 These biases are examined comprehensively in Behavioural Finance: Insights into Irrational Minds and
Markets (Montier, 2002), which links the well-documented biases of Tversky and Kahneman to
investment behaviour.

5 Although the recognition of investor confidence as a focus for recent studies is typically regarded as
a recent development, it connects with the view of markets prior to the advent of the MM propositions.
We are reminded, for example, of Keynes’ animal spirits and his recognition that ‘speculators may do
no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise
becomes the bubble on a whirlpool of speculation. When the capital development of a country
becomes a by-product of the activities of a casino, the job is likely to be ill-done’(Keynes, 1936).

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The implications of cognitive psychology represent a valid dimension in corpo-
rate financial decision making. Nevertheless, we observe that the scope of such
contributions is restricted to a micro-level focus on understanding how the tradi-
tional elements of (i) rational behaviour, (ii) the CAPM, and (iii) efficient markets
are perturbed by the cognitive biases of the individual decision maker, about
which the core paradigms remain fixed. In effect, behavioural finance is allowed
only a narrow interpretation, which fails, for example, to incorporate the social-
ization of the workplace and the dynamics of decision making in groups. Thus,
although following the GFC the term behavioural finance has become in vogue,
it would be a mistake to think that corporate finance has been liberated from
its MM antecedents and that the humanity of business (as understood prior to
the MM propositions) has been reinstated. We continue to observe finance
through the eyes of the old paradigms. The impact of broader behavioural and
strategic considerations on the conditioning of human enterprise continues to be
avoided.

In response, I consider in the following section how the diverse literature in the
area of strategic management might be integrated with that of corporate finance.

TOWARDS A CORPORATE MANAGEMENT CONTEXT
FOR BUSINESS FINANCE: REPUTATION, COMMITMENT AND TRUST

The firm typically faces a complexity of possibilities about which it ‘simply does not
know’ and for which there exists the possibility of surprise. In addition, because the
future holds genuine uncertainty, there exists the genuine possibility of calamity.
Because the firm is unable to assess future cash estimates on the basis of unani-
mously agreed upon probability density functions for every possible future state, it
faces a problem of fundamental uncertainty in specifying the parameters in any
given quantitative market valuation model. Following the GFC, we now counte-
nance the fact that, fundamentally, things can go wrong. We recognize that financial
activities are often highly imperfect and that financial markets are unstable and
evolving.

Within such levels of uncertainty, the MM propositions hold that corporate
finance can be grounded on fundamental laws of cause and effect, such that, for
example, a positive NPV equates with an increase in share value. The teaching of
corporate financial management consequently exhorts that risk and uncertainty can
be encapsulated in a single NPV calculation. Thus, a firm’s projects can be lined up
with given cash flows and shareholder wealth maximized by choosing the projects
with the highest NPVs. But this reasoning is far too simplistic. Real decisions are
never made in this manner. Even if it were possible to meaningfully attribute
additional earnings into the indefinite future as they might derive from initiatives
taken today, there exists the almost impossible task of estimating the cost of capital
with any degree of accuracy. The cost of capital, in practice, is a nebulous concept.
Fama and French (1997) concede that ‘estimates of the cost of equity are distress-
ingly imprecise’ (p. 178), and have concluded that project valuation is ‘beset with

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massive uncertainty’ (p. 179).6 Yet, even in business schools, investment decision
making within corporations is still taught as the application of cost of capital dis-
counted cash flows. As such, the reality of investment decision making within firms
is grossly misrepresented.

Having removed the invisible hand of a cost of financial capital as that which
works to coordinate the provision and utilization of investment finance in well-
functioning markets, we are obliged to postulate alternative mechanisms of coordi-
nation. Dempsey (1996) acknowledges that NPV calculations cannot realistically
capture the subjective and strategic dimensions of the investment decision and
argues that corporate financial activity is more appropriately recognized and under-
stood within a framework of (i) reputations based on past performance and (ii)
commitment and trust relationships. For example, important investment decisions
are made by personnel who have built their reputations based on their past perfor-
mance; the firm’s clients respond to reputation and integrity; and reputation, status,
and influence are dependent on commitment and trust relationships within and
outside the firm. The outcome is that investment decisions are made by people and
not by NPV calculations. Dempsey draws on Kay’s (1993) ‘capabilities for success’
(reputation and networks of relations leading to innovation), which he interprets in
terms of a reputation/trust perspective.

Consistently, Bruner (2004, 2005), in the context of mergers and acquisitions,
reports that business transactions in this area require trust and firms attain
sustainability built on reputation. For Bruner, reputation can count for a great deal
in shaping the expectations of counterparties. Implicit trust and reputation translate
into more effective and economically attractive business transactions. Bonds of trust
and reputation actually pay. I would argue that the GFC can be understood as these
relationships gone awry, as individuals sacrificed their reputations and that of the
firm, along with trust relationships with their clients, because they were seduced by
short-term bonuses linked to deal making.

Interestingly, Bruner (2004, 2005) argues that the commitment to advance repu-
tation and trust identifies the ethical dimension of business and that unethical
practices cannot be expected to provide a foundation for sustainable enterprise. The
legacy of a firm’s reputation is the foundation of its sustainability and ‘trust rewards’
when a bond with clients and customers is built by trustworthy behaviour. Bruner
(2004) quotes Warren Buffet: ‘We can afford to lose a lot of money. But we cannot
afford to lose one shred of our reputation’ (p. 18). In effect, a framework of repu-
tation and trust incorporates an ethical dimension for corporate financial activity. It

6 It is interesting to observe that NPV calculations were familiar to early textbook writers. For example,
Fisher (1930) considers the choice between alternative investments on the basis of discounted earning
streams, with examples of choosing between the allocation of land to farming, forestry, and mining (p.
133). It is even pointed out that the undesirable time shape of the highest discounted earning stream
can be remedied by lending out some of the proceeds in earlier years and consequently being paid
back with interest in later years. Nevertheless, Fisher states that the choice is being analyzed under
unrealistic assumptions of certainty. See also McGoun (1995), who discusses how the methodology of
reducing uncertainty to probability distributions was well understood in these earlier times, but that
the methods were generally dismissed as not answering managers’ problems facing uncertainty.

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is no longer an add-on to be applied to exceptional circumstances of cheating or
deception. Rather, the behavioural practices of institutions and people simultane-
ously define the finance industry and its ethical behaviour.

CONCLUSION

In a world where all possible outcomes are quantifiable and risk can be quantified
and thereby allowed for, investment decisions are reduced to a quantifiable NPV
calculation. In such a world, it may simply be assumed that a firm’s strategy is
absorbed by calculations. In practice, it is more likely to be the case that the firm’s
investment decisions are absorbed by its strategic priorities, with NPV exercises
representing feasibility calculations. Nevertheless, the finance textbooks continue to
be embedded in a world of quantifiable NPV calculations.

Good lecturers realize that corporate finance cannot be taught without incorpo-
rating what institutions and people actually do and that informed comment, however
anecdotal, should be allowed to contribute to a meaningful exposition of the prin-
ciples. Nevertheless, a theory’s explanatory capability is circumscribed by the meth-
odological approaches it adopts. Thus, with the MM propositions as the paradigm,
those contributions that acknowledge the need to allow for an institutional/
behavioural dimension are confined to confront the paradigm of perfect markets
and present arguments within its terms of reference. For this reason, the textbooks
are advancing only marginally. The GFC is accorded lip service but the subject
matter continues to be based on the same static models, which are accepted as truth.
In the textbooks, both corporate and investment finance remain subjected to laws of
behaviour. Fox (2009) comments that ‘this must be chalked up to the now-universal
convention in economics and finance that until something is said mathematically, it
has not been said at all’ (p. 31).

The NPV/cost of capital framework remains seductive to business schools that
wish to project to students the notion that they are receiving clear and unambiguous
knowledge—along with a tool kit for ensuring the correctness of the firm’s invest-
ment decisions. The graduate MBA student has been equipped to parachute into a
firm and rescue it! But all this is illusion. Indeed, a little knowledge can be danger-
ous. What is required is wisdom, a concept that is more difficult to impart to young
students with little or no experience of the real world. One reason is that young
students are uneasy in the face of ambiguity. Rather than open-endedness, they
prefer precise solutions and the traditional finance textbook approach panders to
this preference. With mature MBA students, who together possess an assortment of
business experiences, the ability to disseminate real-life experiences to the class
while maintaining a structure to the lecture (within the lecture’s time frame) will
always be challenging. So, again, the easy way out is to follow the textbook, trusting
that the (expensive) textbook, by virtue of being a textbook, has authority in the eyes
of the class. At the outset, at least, it does. And good lecturers—with sufficient
anecdotes and observation of relevant news events—are able to impart real-world
wisdom and knowledge. Over-reliance on the textbook, however, will nearly always
result in students coming to feel that they are being sold short and that their course

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experience has been reduced to that of being prepared for their final exam questions,
with only little expectation of the usefulness of their course thereafter.

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Does Capital Structure Matter?
Revisiting Modigliani

and Miller’s Empirical Wor

Using Latin American

and North American Data

Lucas Ayres B. de C. Barros
Alexandre Di Miceli da Silveira

Rubens Famá

ABSTRACT. Modigliani and Miller (M-M) performed the first empiri-
cal test of their capital structure irrelevance propositions in 1958. Their
results confirmed the irrelevance hypothesis. In this paper, the M-M
tests are replicated with contemporary data from Latin American and
North American firms, but with two fundamental differences from
M-M’s original work: (a) the CAPM is used for estimating the cost of a
firm’s equity and (b) fuller specifications for the empirical models are
adopted in order to improve their statistical quality. The results do not
lend support to M-M’s 1958 model, but are in line with their corrected
1963 propositions.

Lucas Ayres B. de C. Barros, MSc, is a Phd Student, Faculdade de Economia,
Administração e Contabilidade da Universidade de São Paulo (FEA/USP) Brazil (E-mail:
lucasayres@hotmail.com).

Alexandre Di Miceli da Silveira, MSc, is a PhD Student, Faculdade de Economia,
Administração e Contabilidade da Universidade de São Paulo (FEA/USP) Brazil (E-mail:
alexfea@usp.br).

Rubens Famá, PhD, MSc, is a Professor, Faculdade de Economia, Administração e
Contabilidade da Universidade de São Paulo (FEA/USP) Brazil (E-mail: rfama@
usp.br).

Latin American Business Review, Vol. 5(3) 2004
http://www.haworthpress.com/web/LABR

http://www.haworthpress.com/web/LABR

RESUMEN. En 1958, Modigliani y Miller (M-M) realizaron el primer
ensayo empírico sobre la irrelevancia de las propuestas sobre la estructura
de capital. Sus resultados confirman la hipótesis de su poca importancia. En
este estudio, los ensayos M-M se reprodujeron utilizando los datos con-
temporáneos obtenidos de empresas latinoamericanas y norteamericanas
usando, sin embargo, dos diferencias esenciales del trabajo original
realizado por M-M: (a) el CAPM se utiliza para estimar el costo del capital
social de una empresa y (b) para mejorar la calidad estadística se han
adoptado especificaciones más amplias para los modelos empíricos. Los
resultados no respaldan el modelo M-M de 1958, pero se encuentran
alineados con las propuestas corregidas en 1963.

RESUMO: Modigliani e Miller (M-M) apresentaram o primeiro
ensaio empírico de suas proposições sobre a irrelevância da estrutura do
capital em 1958. Os resultados confirmaram a irrelevância da hipótese.
Neste estudo, os ensaios de M-M são reproduzidos com dados contem-
porâneos das empresas da América Latina e da América do Norte, mas
com duas diferenças fundamentais do seu trabalho original: (a) o CAPM
é utilizado para estimar o custo do capital social de uma empresa e (b)
especificações mais completas dos modelos empíricos são adotadas para
melhorar a sua qualidade estatística. Os resultados não sustentam o
modelo de M-M de 1958, mas estão de acordo com as suas proposições
revistas de 1963. [Article copies available for a fee from The Haworth Document
Delivery Service: 1-800-HAWORTH. E-mail address: Website: © 2004 by The Haworth Press,
Inc. All rights reserved.]

KEYWORDS. Capital structure, irrelevance proposition, Modigliani
and Miller, Latin America DataIntroduction

INTRODUCTION

Does the way in which a firm is financed somehow influence its
value? Should the answer be negative, then why do different organiza-
tions choose different capital structures? If the answer is positive, then
how, in what direction and to what extent do the proportions of debt and
equity financing affect the value of a firm? Furthermore, how can the
existence of such varied types of available financing instruments be jus-
tified?

44 LATIN AMERICAN BUSINESS REVIEW

http://www.HaworthPress.com

It is difficult to establish when the scientific controversies addressing
these and other issues related to the problem of capital structure began.
Possibly, the first effort to deal with the subject in a more analytically
rigorous manner may be attributed to Durand (1952). Nevertheless, the
foremost work in the field was presented six years later by Modigliani
and Miller (1958), henceforth referred to as M-M. In it the authors pro-
posed that, under certain conditions, the degree of a firm’s leverage1
was irrelevant in determining its market value. In other words, a firm
should continue to have the same average cost of capital whether it
maintained a structure of high leverage, or one of relatively low lever-
age. Since the release of their seminal work, M-M’s propositions have
motivated abundant academic debate, contributing to further interest on
the subject.

The empirical and theoretic works that have followed the original
article by M-M have approached the subject from various different an-
gles and their conclusions and propositions are somewhat heteroge-
neous. Some more or less confirm the hypothesis of indifference of
capital structure. Others reject it fairly strongly. Among those who re-
ject the hypothesis of indifference, there is no consensus as to the spe-
cific direction of the relationship between capital structure and the
value of firms. Harris and Raviv (1991) presented a survey of the main
theoretical trends that have emerged since the early works, and of the
empirical evidence produced on the subject, showing the panorama of
its diversity.

The first test of M-M’s propositions was presented by the authors
themselves in their work of 1958, using data from American electric util-
ity and oil companies. Their results showed that, at the time, there was no
evidence of a significant relation between the average cost of a firm’s
capital and its degree of leverage, confirming the indifference of capital
structure hypothesis. They also confirmed that the cost of a firm’s equity
increased linearly as leverage increased, another prediction of their
model.

However, the M-M tests were affected by limitations of various types.
Most of them, as the authors themselves acknowledge (Modigliani and
Miller, 1958, pg. 282), were possibly related to the measurement of the cost
of equity and the average cost of a firm’s capital. In 1958, there was no
model from which theoretically acceptable estimates of the cost of equity
could de drawn. A theory of market equilibrium that permitted calculating
such a variable only emerged years later with Sharpe (1964) and Linter
(1965) and their Capital Asset Pricing Model (CAPM). Although also
fraught with controversy, the CAPM remains the model most utilized on

Barros, Silveira, and Famá 45

capital markets for calculating the return demanded by the shareholders of
a firm in order to compensate them for the risk of their investment.

Would the results reported by M-M be the same if advancements in
the theory of finance, such as the CAPM, had been available in 1958?
Would the authors’ conclusions be the same if, moreover, the specifi-
cations of the statistical models they used had been different? Above
all, would their findings have been corroborated by current data? Un-
fortunately, the first two questions cannot be answered. One of the rea-
sons why the CAPM is today considered one of the most suitable
models for estimating the cost of firms’ equity is precisely the fact that
it is broadly accepted and used by investors. Thus, one should not ex-
pect that the CAPM would bring about the best assessment of the re-
turn demanded by the shareholders of a firm, prior to its formulation. It
is possible, however, to answer the last question, and that is the pur-
pose of this work. Specifically, an empirical study similar to that pre-
sented by M-M in 1958 is conducted on firms of the electric and
petroleum industries in the USA and in Latin America, using data of
2000. With regard to the original work, two basic differences are note-
worthy: (a) the CAPM is used to calculate the cost of each firm’s eq-
uity and (b) fuller specifications are adopted for the empirical model,
aiming at improving its statistical quality and therefore reaching more
precise conclusions.

EARLY APPROACHE

“Traditionalists” and M-M

According to the point of view sometimes referred to as “tradition-
alist,” firms can and must seek to achieve an optimal combination of
debt and equity capital with a view to maximizing their market value.
Value maximization takes place through the minimization of the over-
all cost of the capital used by a firm to finance its activities. Durand
(1952) was one of the pioneers to investigate these possibilities. Ac-
cording to the author, if investors agree on a method for pricing the
firm based on its expected future cash flow discounted to present
value, it should be possible, keeping the expected cash flow constant,
to increase the firm’s value through the reduction of the discount rate;
that is to say, the opportunity cost of the capital employed. Durand
(1952), however, admits that it will not necessarily be possible to re-

46 LATIN AMERICAN BUSINESS REVIEW

duce the cost of capital by altering the proportions of equity and debt
in the firms’ liability.

As a rule, debt should be cheaper than equity capital because the for-
mer entails a contractual obligation for payments by a firm, whereas the
latter represents a residual right on its cash flow. However, an increase
of relative indebtedness (leverage) will not always bring about a reduc-
tion of the weighted average cost of capital (WACC).2 If the firm is al-
ready highly leveraged, an increase in its ratio of debt to total capital
may significantly increase the risk of insolvency. Consequently, inter-
est rates for new loans may rise. The risk associated with possible finan-
cial difficulties will also affect the shareholders, contributing to an
increase in the cost of equity. These two effects combined may cause
the WACC to remain constant or even to increase, despite the relative
increment in debt financing. Nevertheless, the “traditionalist” position
states that the cost of debt will remain approximately unchanged for
“moderate” levels of leverage, understanding “moderate” as a level of
indebtedness that does not jeopardize a firm’s ability to honor its con-
tractual obligations. Likewise, the cost of equity should also be insensi-
tive to “reasonable” variations in financial leverage. Thus, a firm should
seek more debt financing up to the point at which its WACC reaches its
minimum. These and other issues are discussed by Durand (1952).

Modigliani and Miller (1958) contest the “traditionalist” outlook. In
a work that became the hallmark for the study of the subject, the authors
proposed that capital structure is irrelevant for determining the value of
a firm if certain restrictions are met. Although this possibility had al-
ready been presented by Durand (1952), M-M were the first to formally
describe the mechanism through which the indifference was assured in
a context of partial market equilibrium. Since their original work, an im-
pressive amount of research in the field of capital structure has contrib-
uted to a better understanding of the related phenomena. Controversies
involving disagreement between the “traditionalists” and M-M have
lasted for many years and are reflected in works such as those of Durand
(1959), Modigliani and Miller (1959), Weston (1963), Solomon (1963),
Boness (1964), Brewer and Michaelsen (1965) and Modigliani and
Miller (1965). These and other related works may be found in Archer
and D’ambrosio (1967).

The Propositions of Modigliani and Miller

The 1958 work by M-M is based on the formulation and demonstra-
tion of three propositions regarding the relationship between capital

Barros, Silveira, and Famá 47

structure and a firm’s value, as well as between capital structure and a
firm’s investment decisions. Their Proposition I was formulated as fol-
lows (Modigliani and Miller, 1958, pg. 268):

. . . the market value of any firm is independent of its capital struc-
ture and is given by capitalizing its expected return at the rate r

appropriate to its class.

In other words, Proposition I states that the proportions of debt and
equity as sources of financing are completely irrelevant for determining
a firm’s market value. That happens because different combinations of
the distinct types of financing instruments will not alter the total or aver-
age cost of the capital used by the firm. Using M-M’s notation, the total
market value of the jth firm (Vj) belonging to class k will be given by (1),
where X j corresponds to the expected return on the assets owned by the
company, and rk is the appropriate discount rate. Thus, rk corresponds
to the average cost of capital and is the rate that compensates all inves-
tors for the risks to which they are exposed. The consideration of risk is
implicit in the concept of class formulated by the authors; that is to say,
all firms belonging to a given class, k, have the same level of risk. Finally,
rk is equivalent to the return demanded by the shareholders of a firm
that is not leveraged (not financed with any debt).

V
X

j
j

=
r

(1)

The equation shown in (1) calculates the present value of the ex-
pected, perpetual cash flow produced by a firm with zero growth. The
supposition of no growth is a simplification used to facilitate the exposi-
tion and is not a binding restriction.

Proposition I by M-M is demonstrated using a no arbitrage argument
in markets where:

• all debts are risk free,
• individuals can borrow and lend at the risk free rate and
• there are no transaction costs.

Under such conditions, the authors demonstrate that any investor can
reproduce the leverage of a firm by making a personal loan. He could
also undo it by purchasing debt securities. One way or another, the in-

48 LATIN AMERICAN BUSINESS REVIEW

vestor will have an opportunity for arbitrage, meaning immediate and
risk free profits, whenever a non-leveraged firm presents a different
market value from that of a leveraged one, as long as both have the same
expected cash flow X and belong to the same class. In an efficient mar-
ket, the possibility of arbitrage should force the parity of values, render-
ing the proportions of equity and debt irrelevant for determining the
total value of any firm within a given class k. That is justified because
the WACC will be constant and equal to rk (which is also the cost of eq-
uity of a non-leveraged firm) independently of the relative amount of
debt and number of shares issued by the firm.

Implicitly or explicitly, M-M utilized in their work various other as-
sumptions, some of them quite restrictive. Among these, the model as-
sumes that (Copeland and Weston, 1988):

• there are no bankruptcy costs,
• only two types of claims are issued by firms: risk free debt and

(at-risk) equity,
• all firms belong to the same risk class,
• there is no information asymmetry between individuals inside and

outside of the firm (investors and managers, for example),
• managers always seek to maximize shareholders’ wealth (there are

no agency costs), and
• there are no taxes.

Certainly, most of these assumptions are unrealistic. However, some
of them may be relaxed without materially changing the main findings.
Rubinstein (1973), for instance, shows that the presence of risky debt
leaves the original results totally unchanged.

Stiglitz (1969) demonstrates the M-M theorems using other argu-
ments. The author works in a state-preference context and develops a
general equilibrium analysis to show that the M-M results are more stal-
wart than was previously thought. According to Stiglitz (1969), validity
of the original results does not, for example, rest upon the existence of
“risk classes,” nor on the degree of competition in capital markets. It is
also independent from the agreement of all individuals about the proba-
bility distribution of future returns (homogeneous expectations).

Other assumptions, explicit or implicit in the original formulation,
nevertheless remain intact as significant limitations of M-M’s model. An
example is the assumption of no taxation of a firm’s profits. Inclusion of a
corporate income tax was, however, carried out in the original M-M work

Barros, Silveira, and Famá 49

of 1958. In it, the authors assert that the same results suggesting the irrele-
vance of capital structure are attained. Later, however (Modigliani and
Miller, 1963), they corrected their reasoning, pointing to an error in the
original work and proposing a new formulation when a corporate tax rate
greater than zero exists. That correction is outlined below.

If VU corresponds to the value of a non leveraged firm (with no debt
in its capital structure), VL is the value of a leveraged firm, tc is the cor-
porate income tax rate, and D is the market value of the firm’s perma-
nent debts, then it can be shown that (Modigliani and Miller, 1963).

V V DL U c= + τ (2)

The relation in (2) indicates that the value of a leveraged firm is equal
to the value of a non leveraged firm, plus the present value of the fiscal
benefit, or tax shield, provided by debt and represented by tc D (Cope-
land and Weston, 1988). It may be noted that VL = VU if tc= 0.

Stated differently, in the absence of a corporate income tax, Proposi-
tion I remains valid and the financing structure of the firm will still be ir-
relevant for determining its value. The importance of tc in the analysis
comes from the fiscal deductibility of the interest paid as a service of the
firm’s debts. Thus, the greater the leverage, the smaller will be the
amount of income tax to be paid for the same profit before taxes, evi-
dencing a considerable benefit provided by debt financing.

As previously mentioned, Proposition I implies that WACC = r(from
hereon the underwriting k will no longer be used) in the absence of
taxes. However, in the presence of t

c
π0, this formulation must be

changed to:

WACC i

D S
c d= − − +

r rτ ( ) (3)

It must be noted that in (3), given that r is greater than id (this should
be true because equity is riskier than debt), the weighted average cost of
capital will drop with the increase of leverage because of the tax shield
associated with debt.

M-M’s Proposition II, also formulated in their work of 1958, makes
explicit the mechanism by which the weighted average cost of capital
remains constant independently of the proportions of D and S. If, as it
is reasonable to admit, id < is, then, at first sight, the WACC should

50 LATIN AMERICAN BUSINESS REVIEW

drop with the use of relatively more debt financing, at least within
“moderate” levels of leverage that would not jeopardize the firm’s
ability to remain solvent. This is precisely the “traditionalist” point of
view. In opposition to this idea, M-M show that any increase in finan-
cial leverage translates into a higher risk for the firm’s shareholders.
The perception of increased riskiness will eventually drive up the cost
of equity (is). Therefore, two forces will act simultaneously whenever
D/(D + S) increases: on the one hand, the WACC will decrease be-
cause id < is; on the other hand, the WACC will increase because is will rise due to the added risk. According to M-M, the interaction of these two opposite movements results in a null effect upon the WACC, which will remain equal to r. The expression in (4) shows how is var- ies along with D/S (at different times the authors use D/(D + S) or D/S as the measure of leverage).

i i
D

S
s d= + −r r( ) (4)

Looking at (4), one can note that in the absence of financial lever-
age (D = 0), is = r. is will thus grow linearly with an increase of D/S,
and the WACC will remain constant. Such relations are shown in
Figure 1.

In their article of 1963, M-M show how the cost of equity relates to fi-
nancial leverage in the presence of a corporate income tax rate greater
than zero. In this case, the increase in is resulting from the increase in

Barros, Silveira, and Famá 51

i = + ( – i )s dr r
D
S

r
id

WACC = r
D
S

FIGURE 1. WACC and Cost of Equity in the Absence of Taxes

Source: Adapted from Copeland and Weston (1988, pg. 250).

D/S will be smaller than in the previous case, shown in (4), due to the tax
shield generated by debt. This relation is presented in (5).

i i
D

S
s c d= + − −r r( )( )1 τ (5)

Variation of the WACC and of is as leverage increases is shown in
Figure 2.

To summarize, the original propositions of M-M set forth the irrele-
vance of capital structure for determining the value of a firm, as long as
certain restrictive conditions defined by them or implicit in their formu-
lation apply, at least in approximate terms. In 1963, correcting their first
work, the same authors showed that in the presence of a corporate in-
come tax, the proposition of irrelevance was no longer valid. Because of
the fiscal benefit provided by debt, an increase in leverage will lead to a
decrease in the weighted average cost of capital, consequently increas-
ing a firm’s value ceteris paribus.

Figure 2 reveals that the WACC will always decay with an increase
of leverage until the limiting value of r+tc(id-r) when D – •. In this

52 LATIN AMERICAN BUSINESS REVIEW

= + – –i (1 )( i )s c dr t r
D
S

p WACC ( i )= – –r t rc d
D

D + S
(i )r t+ –c d r

i (1 )d c– t

D
S

FIGURE 2. WACC and Cost of Equity When tc > 0

Source: Adapted from Copeland and Weston (1988, pg. 250).

case, the apparent recommendation for a manager is: put the firm con-
tinually into more debt. However, intuitively it does not seem logical
that any firm would increase leverage up to the point where all of its fi-
nancing came from creditors. Thus, the question is how to conciliate in-
tuition with the propositions of M-M.

OTHER APPROACHES AND NEW DEVELOPMENTS

Some answers to the enigma of capital structure appeared as theoreti-
cal models in which important restrictive assumptions of the M-M
model were relaxed. Miller (1977) himself proposed an alternative
model taking into account not only the corporate income tax, but also
the income tax levied upon individual investors (creditors and share-
holders). His results indicate that the tax shield effect induced by debt
may be significantly smaller than the one found by M-M in 1963. An-
other line of research focuses on expected bankruptcy costs, which will
increase following any increase in leverage, thereby restricting the ben-
efit associated with debt financing and permitting the existence of an
optimal combination of equity and debt. The works of Baxter (1967),
Warner (1977), Altman (1984) and Weiss (1990), among others, follow
this trade-off approach.

Harris and Raviv (1991) classify the more recent contributions on the
subject of capital structure into four major categories. The first lists the
works based upon so-called “agency costs,” focusing on the conflicts of
interest between creditors and shareholders/managers and between
shareholders and managers of a firm. Noteworthy in this field are the
works of Myers (1977), Jensen (1986) and Stulz (1990). The second
category includes the studies inspired by the notion of informational
asymmetry among agents who are inside in contrast with those who are
outside the organization, and encompasses studies on signaling. The
works of Ross (1977), Myers and Majluf (1984) and Myers (1984) are
good examples of that approach. The third major category includes the-
ories based on product/input market interactions, approaching the choice
of a firm’s capital structure as part of its marketing and competitive
strategies, or as a decision that intrinsically depends on the characteris-
tics of its products/inputs. Important contributions to this stream of
analysis were offered by Titman (1984), Balakrishnan and Fox (1993)
and Maksimovic (1986), among others. Finally, the authors survey the
theories driven by corporate control considerations, involving the im-
plications for a capital structure of voting rights and the possibility of

Barros, Silveira, and Famá 53

hostile takeovers. Along this line, two of the more important works are
attributed to Stulz (1988) and Harris and Raviv (1990).

Other approaches, besides those mentioned by Harris and Raviv
(1991), continue to contribute to the understanding of the subject.
For instance, one recent and promising line of research explores the
tendency of managers to time the market by, for example, issuing
shares when prices are high and repurchasing when prices are low,
exploiting what is sometimes referred to as “windows of opportu-
nity” in capital markets. One of the milestones in this field is the
work of Baker and Wurgler (2002). Another promising approach
models capital structure decisions by assuming that managers are
excessively optimistic by nature, which leads them to overvalue the
risky securities issued by the firm, resulting in underinvestment or
overinvestment problems (see Heaton, 2002).

EMPIRICAL STUDY

The M-M test

In performing an empirical test of their initial propositions, Modigliani
and Miller (1958) used American data for the years 1947 and 19483 from
43 electric utilities and data for the year 1953 from 42 oil companies.

First, their procedure consisted in constructing a simple regression
model with the firm’s average cost of capital as the dependent variable
and its degree of leverage as the independent variable. The model was
estimated by ordinary least squares (OLS). Based on (1), M-M define
the average cost of capital as

rk
X

V
=

(6)

Where V is the total market value of a firm belonging to class4 k.
V corresponds to the sum of the market value of the firm’s debts (D)
with the market value of its common shares (S). For the oil compa-
nies, D included all long term as well as some short term liabilities.
For the electric utilities, only long term debt was considered. Ac-
cording to the original definition, X τ represented the expected total
income net of taxes generated by the firm. However, this information
was not directly available. As a proxy, M-M used the average value

54 LATIN AMERICAN BUSINESS REVIEW

of actual returns net of taxes from 1947 and 1948 for the electric util-
ities. Actual net returns from 1953 were used for the oil companies.
Net returns was defined as the sum of interest, preferred dividends
and stockholders’ income after the deduction of corporate income
taxes. Leverage was operationally defined as the ratio D/(D + S) =
D/V. Designating the average cost of capital as x and leverage as d,
both in percentages, M-M found the following results (standard er-
rors of the coefficients in parentheses):

Electric Utilities x = 5. 3 + .006d
(.008)

Oil Companies x = 8. 5 + .006d
(.024)

These results lend support to Proposition I. In both cases, it is not pos-
sible to reject the null hypothesis that the coefficient of the independent
variable is zero at usual significance levels (the t-statistics for the electric
utilities and oil companies are respectively 0.75 and 0.25, and their asso-
ciated p-values are 0.46 and 0.8). In short, the data does not show any im-
portant relationship between leverage and the average cost of the firm’s
capital. Furthermore, it can be noted that the signs of the slope coeffi-
cients are positive, contrary to what would be expected by the “tradition-
alist” hypothesis or even by M-M’s corrected model of 1963.

To test Proposition II, M-M estimated a regression with the cost of
the firm’s equity as the dependent variable and leverage as the inde-
pendent variable. According to (4), leverage should now be defined as
the ratio D/S. The cost of equity, represented by is in (4), was defined as

i
S

s =
π τ

(7)

where π τ is the expected net income accruing to the shareholders, and S
is the market value of the shares. Just as X τ τπ, is not directly observ-
able. As an approximation, the authors used arithmetic averages of ac-
tual net income available to shareholders reported in 1947 and 1948 for
the electric utilities, and in 1952 and 1953 for the oil companies.5

Letting z represent is, as defined in (7), and h represent D/S, both in
percentages, M-M obtained (standard error of the coefficients in paren-
theses):

Barros, Silveira, and Famá 55

Electric Utilities z = 6.6 + .017h
(.004)

Oil Companies z = 8.9 + .051h
(.012)

The t-statistics for the electric utilities and oil companies both have the
same value of 4.25, with a p-value of approximately zero. Such results
point towards the existence of a highly significant relationship between the
cost of equity and leverage. Just as was predicted in their model, M-M veri-
fied that an increase in leverage would be followed by an increase in the
cost of equity. The linear relationships found by M-M are similar to those
graphically portrayed in Figure 1, adequately supporting their 1958 model.

As shown in Figure 1, the propositions of M-M stated that no curvi-
linear relationship between the average cost of capital and the degree of
leverage should exist, contrary to the “traditionalist” approach. To ver-
ify that, the authors specified a third empirical model, adding a qua-
dratic term to the first regression equation. Its coefficient, however,
proved insignificant.

Test of the M-M Propositions with Contemporary Data

One of the most severe limitations of the test procedure used by M-M
refers to the operational definition of the variables. Notably question-
able are the proxies used for the average cost of capital defined in (6)
and the cost of equity defined in (7). In 1958, there was no theoretical
model upon which one could acceptably base estimate rk and is. An
equilibrium model that was easily applicable would only emerge with
the works of Sharpe (1964) and Lintner (1965), introducing the Capital
Asset Pricing Model–CAPM. In its original formulation, the CAPM de-
fines the cost of equity as

i i i i ßs f M f= [ – ] (8)

where is is the equilibrium cost of equity, or the return expected by the
firm’s shareholders, if is the return provided by the risk free bond, im corre-
sponds to the expected return of the market portfolio and b measures the
systematic risk associated with the firm. Comparing (8) to (7), it might be
questioned if the M-M model and the CAPM are compatible, given that in
the original M-M formulation there was no consideration whatsoever about

56 LATIN AMERICAN BUSINESS REVIEW

systematic risk and its role in estimating is. Rubinstein (1973) shows that
the two theories are perfectly compatible. The author demonstrates, for in-
stance, the mechanism through which b increases with leverage and thus
leads to a higher cost of equity. Therefore, Proposition II, as stated by
M-M, is still valid within the CAPM framework.

If the M-M and CAPM formulations for is are equivalent, it is possible
to replace the definition in (7) by the one presented in (8). Likewise, the
definition of rk shown in (6) is replaced by the weighted average cost of
capital–WACC (see endnote number 2). In calculating the WACC, we
estimate is using the CAPM and id is given by the observed yield to matu-
rity of the firms’ long term debt securities.

Data and Empirical Model

We use data from 68 American and 33 Latin-American electric utili-
ties, and 93 American and 16 Latin-American oil and gas producers for
the year 2000. The data is available in the BLOOMBERG database and
the analysis follows the procedures described by M-M in their 1958
work, based on OLS regression estimates.

Initially, to test Proposition I, we construct an empirical model with ex-
actly the same specification as the one built by M-M and shown in section
The M-M Test, Thus, the average cost of capital appears as the dependent
variable and the firm’s leverage is the only independent variable. However,
differently from M-M, the dependent variable is defined as the WACC and
the cost of the equity is estimated using the CAPM. We make use of the
WACC and the is values for each firm provided by BLOOMBERG, as
these estimates are widely used by investors. We define leverage as D/V,
including in D all long term debt as well as preferred shares.

With this initial specification and using the same notation as M-M,
the following results appear (t-statistics in parentheses):

American Electric Utilities Latin-American Electric

Utilities

.059+.006x = d =.094–.027

(.666

x d

) (–2.44)

American Oil and Gas Producers Latin-American Oil and Gas

Producers

=.077–.002x d =.091–.05x d

(–.43) (–2.42)

Barros, Silveira, and Famá 57

The above results still support M-M’s 1958 indifference hypothesis
for the American firms of both industries. The p-values of the slope
coefficients are 0.5 and 0.67 for the electric utilities and oil and gas
producers, respectively. However, for the Latin-American firms the
M-M results are not maintained. The slope coefficients are statisti-
cally different from zero at the 5% significance level in both sectors.
The signs of the coefficients are also reversed and a strong negative re-
lation between financial leverage and average cost of capital is re-
vealed, thus opposing Proposition I. On the other hand, considering
that these firms are subject to high corporate income tax rates, the esti-
mates seem to corroborate the conclusions of the M-M work of 1963,
confirming the importance of the tax shield induced by debt. How-
ever, with the exception of the estimates for the Latin-American oil
and gas producers, all regressions exhibit poor statistical quality, as
the rejection of the hypotheses of normality and homoscedasticity of
the error terms suggest.6 This was especially true for the models in-
volving American firms. One could also strongly suspect that the error
terms are not uncorrelated with the regressor in these models, intro-
ducing possible biases in the estimates. This last issue is addressed be-
low.

The fact that, in their original work, M-M used such a simple specifi-
cation, with one single independent variable, is one of the major sources
of criticism of their procedures. Weston (1963), for instance, argues that
variables such as firm size may, in practice, influence leverage as well
as the average cost of capital. Their absence in the empirical formula-
tion could then introduce an omitted variables bias in the estimate of the
coefficient of interest. In addressing this problem and in trying to im-
prove the statistical quality of the estimated models, we use a few con-
trol variables. Among the most natural candidates are the firm’s size,
measured by its total capital employed (TC), systematic risk, measured
by the firm’s b, the corporate income tax rate to which the firm is effec-
tively submitted (T), the cost of its debt financing (id) and the relative
amount of short term liabilities (STL) in its financial structure. Control-
ling for systematic risk seems to be of particular importance, given the
model’s assumption that all firms are in the same risk class. Various al-
ternative specifications were attempted, and the ones reported are those
with greatest statistical adequacy.7 Some of the results are shown below
(t-statistics in parentheses).

58 LATIN AMERICAN BUSINESS REVIEW

American Electric Utilities Latin-American Electric
Utilities

x =.082–.0014d+.017 –.056 –.024 =.066–.022ß T STL x d+.034 .029T

(–4.34)
ß–

(–5.32)
American Oil and Gas Producers Latin-American Oil and Gas

Producers

039x =. –.009 0024 .38 =.098–d+. b+ i xd .035 .053

(–4.35)
d– T

(–3.60)

After introducing fuller specifications and substantially improving
the statistical quality of the models, it is noteworthy that all results are
opposed to those reported by M-M in 1958. The coefficients of d are
now statistically significant at the 5% level in the four regressions, indi-
cating a clearly negative association between leverage and the average
cost of capital. Alternative specifications of these models yield similar
conclusions. It is also noted that the estimated coefficient for the firm’s
size was negligible in all specifications.

In the test of Proposition II, the only difference from the original
M-M procedure is the operational definition of the cost of the equity,
which is estimated with the CAPM. Results are reported below (t-statis-
tics in parentheses):

American Electric Utilities Latin-American Electric
Utilities

=.076+.0005z h =.095–.000

(.40)

z h

(–.12)

American Oil and Gas Producers Latin-American Oil and Gas
Producers

=.082+.0003z h =.09–.0003z h

(1.37) (–1.32)

Once again, all results contradict the predictions of the original 1958
model, as well as the conclusions based on M-M’s empirical tests. The
null hypothesis that the slope coefficient is zero cannot be rejected, at
the 5% significance level, in any case. In other words, the data shows no
significant relationship between the cost of equity financing and the de-
gree of leverage, contradicting Proposition II. However, it must again
be stressed that such results are not incompatible with the M-M model

Barros, Silveira, and Famá 59

of 1963. As shown by (5), the tax shield effect provided by debt may
substantially reduce the impact of leverage on is and could easily ac-
count for the insignificance of the estimated regression coefficients.

The regressions reported above, estimated with Latin-American data,
show satisfactory statistical quality, but that was not the case with the
American firms. Several alternative specifications were then tested.
Also, outlying observations were removed in some cases. In any cir-
cumstance, though, the results shown above remained practically unal-
tered, proving to be quite stalwart. In fact, adding control variables,
including b, only produced even less significant coefficients for h.

According to the “traditionalist” point of view, there should be a
curvilinear relationship between the average cost of capital and a firm’s
leverage. For moderate levels of debt financing, the WACC should drop
with an increase of leverage because debt is cheaper and interest pay-
ments can be deducted from taxable income. At some point, however,
the risk of bankruptcy caused by excessive leverage would become a se-
rious concern and investors would start driving the WACC upwards if
the firm continued to replace equity with debt financing. If that were the
case, we should be able to find a point at which the WACC was mini-
mal, thus maximizing the firm’s market value. The empirical equation
used by Modigliani and Miller (1958) to test that possibility is shown
below.

x d
d

d
= + +α α α1 2 3

1( – )
(9)

a1, a2 and a3 are regression coefficients. The reduced form described in
(9) was estimated for the American and Latin-American firms. In general,
results showed no evidence of any non linear relationship between the vari-
ables; that is to say, a3 was not statistically significant in nearly all cases. Nei-
ther was any clear curvilinear pattern detected in the regressions of z in h.

SUMMARY AND CONCLUDING REMARKS

Although the academic controversies concerning the issue of capital
structure are more than 40 years old, they are still far from over. Since
Durand (1952), and especially since Modigliani and Miller’s pioneering
works of 1958 and 1963, innumerous alternative approaches to the sub-

60 LATIN AMERICAN BUSINESS REVIEW

ject have proliferated. Remarkably, though, M-M’s models remain as
some of the most influential in this field of research.

The first sections of this work sought to outline a rather summarized
panorama of the historical evolution of research on capital structure, fo-
cusing on the seminal ideas of M-M and on their opposition to the point
of view often referred to as “traditionalist.”

In the empirical study, the empirical test developed by M-M them-
selves in 1958 was described. Their results confirmed their original
propositions, according to which the capital structure of a firm was ir-
relevant for determining its market value, even in the presence of a posi-
tive corporate income tax rate. It was then argued that the testing
procedures used by the authors suffered from severe limitations, espe-
cially concerning the operational definition of the average cost of capi-
tal and of the cost of a firm’s equity. Also, the specifications of the
empirical models were too simplified and inferences based on them
seem questionable.

We then replicated M-M’s tests with contemporary data, introduc-
ing two basic distinguishing features from their original work: (a) the
CAPM was used for estimating the firms’ cost of equity and (b) fuller
specifications for the empirical models were adopted in order to en-
hance their statistical quality and produce more appropriate infer-
ences.

The results of the empirical research do not corroborate with the
M-M model of 1958 and are similar to those reported by Weston (1963).
In general, it was found that more leverage is associated with a smaller
average cost of capital for both American and Latin-American electric
utilities and oil and gas producers. Also, the data did not show evidence
of any significant relationship between leverage and the cost of a firms’
equity. Finally, no curvilinear relationships between the average cost of
capital and leverage, or between the cost of equity and leverage were
found. Thus, although capital structure seems to be relevant in deter-
mining a firm’s value, it was not possible to identify any optimal mix of
debt and equity financing.

One possible justification for the results found is the tax shield feature
associated with debt financing. The deductibility of interest payments is
an advantage of debt in the presence of a corporate income tax. That was
examined by M-M in their 1963 work. In this context, our evidence can-
not be qualified as surprising. Much to the contrary, these should pre-
cisely be the expected results if the original model (Modigliani and
Miller, 1958) had been correctly extended to a world where there is a cor-
porate income tax, which was finally accomplished in 1963. Of course,

Barros, Silveira, and Famá 61

some other theories, among the many that have followed since M-M’s
early works, could also play significant roles in explaining the empirical
patterns identified in this research.

NOTES

1. In this paper the term “leverage” is to be understood as the “financial leverage”
resulting from the existence of a fixed expense, in this case the interests charged to a
firm as a periodic service of its debt. Therefore, an increase in “leverage” results from
an increase of the firm’s indebtedness.

2. The WACC may be represented as

WACC = id
D

D S+
is

D S+
,

where id is the cost of debt, is is the cost of equity, D is the market value of the firm’s
debts, S is the market value of its shares and therefore, D + S represents the firm’s total
value. If other forms of financing are used, they may be directly aggregated to the
above equation, according to their cost and to the proportions in which they are used.

3. The average values of the two years were used.
4. The authors approximate the concept of “class” by using firms from the same indus-

try. In that sense, it is assumed that all oil companies, for example, belong to the same class.
5. For the oil companies the authors further made a minor adjustment for the varia-

tion in the size of the company from one year to the other.
6. Non-normality and heteroscedasticity were verified by standard testing proce-

dures and are particularly problematic considering that most of the samples available
are considerably small, especially in the Latin-American case.

7. Diagnostic analyses were carried out based on testing procedures such as the
Jarque-Bera normality test and the White test for heteroscedasticity and correct linear
specification. For model selection purposes, the adjusted coefficient of determina-
tion and the Schwarz Criterion were used. In some cases, when the re-specification of
the model was not sufficient to ensure an adequate statistical quality, a few outlying
observations were removed. The removal of outliers, though, did not materially af-
fect the magnitude and sign of the coefficients of interest.

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Balakrishnan, S. and Fox, I. (1993). “Asset Specificity, Firm Heterogeneity and Capi-
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62 LATIN AMERICAN BUSINESS REVIEW

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Brewer, D. E. and Michaelsen, J. B.(1965). “The Cost of Capital, Corporation Finance,
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Copeland, T. E. and Weston, J. F. (1988). “Financial Theory and Corporate Policy,”
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Durand, D. (1952). “Cost of Debt and Equity Funds for Business: Trends and Problems
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______(1959). “The Cost of Capital, Corporation Finance, and the Theory of Invest-
ment: Comment,” American Economic Review, Vol. XLIX, No. 4, pp. 261-297.

Harris, M. and Raviv, A. (1990). “Capital Structure and the Informational Role of
Debt,” Journal of Finance, Vol. 45, No. 2, pp. 321-349.

______(1991). “The Theory of Capital Structure,” Journal of Finance, Vol. 46, No. 1,
pp. 197-355.

Jensen, M. C. (1986). “Agency Costs of Free Cash Flow, Corporate Finance and Take-
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Modigliani, F. and Miller, M. H. (1959). “The Cost of Capital, Corporation Finance,
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pp. 655-669.

Modigliani, F. and Miller, M. H. (1963). “Corporate Income Taxes and the Cost of
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Modigliani, F. and Miller, M. H. (1965). “The Cost of Capital, Corporation Finance,
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Journal, Vol. 30, No. 2.

64 LATIN AMERICAN BUSINESS REVIEW

912

SUMMARY OF THEORIES IN CAPITAL STRUCTURE DECISIONS

Herczeg Adrienn
University of Debrecen Centre of Agricultural Sciences
Faculty of Agricultural Economics and Rural Development
herczega@agr.unideb.hu

Abstract Defining the optimal capital structure is a critical decision for any
organization. This decision is important not only because of the need to maximize returns,
but also because of the impact such a decision has on an organization’s ability to deal
with its competitive environment. There are many theories for this theme, but all the same,
researchers have not found the optimal capital structure.

In Hungary the capital structure of enterprises changed significantly since 1990, but it is
true, that their decisions about the capital can not fit with neither theoretical appeal totally.
There is no universal theory of the debt-equity choice, and no reason to expect one.

Keywords capital structure, Modigliani Miller, enterprises

JEL classification: M4

1. Introduction

In traditional corporate finance, the objective in decision making is to maximize the value
of the firm. A narrower objective is to maximize stockholder wealth. When the
stock is traded and markets are viewed to be efficient, the objective is to maximize the
stock price. “Stock price maximization, firm value maximization and stockholder wealth
maximization is not the same. Stock price maximization is the most restrictive of the three
objective functions. It requires that managers take decisions that maximize stockholder
wealth, that bondholders be fully protected from expropriation, that markets be efficient
and that social costs be negligible.
Stockholder wealth maximization is slightly less restrictive, since it does not require that
markets be efficient.” (Damodaran, 1994)
Firm value maxmization is the least restrictive, since it does not require that bondholders
be protected from expropriation. Thus, when we make the argument that an action by a
firm (such as investing or financing) increases firm value, this increase in firm value will
necessarily translate into increasing stockholder wealth and stock price only if the more
restrictive assumptions hold. Conversely, an action that increases the stock price in a
world where the less restrictive assumptions do not hold, may not necessarily increase
firm value.
As the Figure 1. shows, all other goals of the firm are intermediate ones leading to firm
value maximization, or operate as constraints on firm value maximization. The objective
of maximizing stock prices is a relevant objective only for firms which are publicly traded.
For firms which are not publicly traded, the objective in decision making is the
maximization of firm value. Since firm value is not observable and has to be estimated,
what private businesses will lack is the feedback, sometimes unwelcome, that publicly
traded firms get when they make major decisions. (Damodaran, 1994)

913

Figure 1. The classical objective function
Source: Damodaran, 1994

In this way, one of the most important issues in corporate finance is responding “How do
firms choose their capital structure?”. Locating the optimal capital structure have for a long
time been a focus of attention in many academic and financial institutions that probe into
this area. This is comprehensible as there is a lot of money to be made advising firms on
how to improve their capital structure.

There are many methods for the firm to raise its required funds, the most basic
instruments are stocks or bonds. The mix of the different securities is known as its capital
structure, so it can be defined as the combination of

debt

and equity used to finance a
firm. And the target capital structure is the ideal mix of debt, preferred stock and common
equity with which the firm plans to finance its investments.

2. Modigliani and Miller Proposition I-II /No tax scenario/
The greatest breakthrough in theory of optimal capital structure came with Modigliani and
Miller’s theorem, which specifies conditions under which various corporate financing
decisions are irrelevant. Essentially, they hypothesized that in perfect markets, it does not
matter what capital structure a company uses to finance its operations. They theorized
that the market value of a firm is determined by its earning power and by the risk of its
underlying assets, and that its value is independent of the way it chooses to finance its
investments or distribute dividends. The assumptions of MM proposition I are the
followings:

 Homogeneous expectations

 Homogeneous business risk

 Perpetual cash flows

 Perfect capital market
o Perfect competition (every one is a price taker)
o Firms and investors can borrow and lend at the same rate

914

o Equal access to all relevant information
o No transaction cost (taxes or bankruptcy costs)

(Modigliani – Miller, 1959)

In this circumtances MM Proposition I. concerns about the irrelevancy of the value to
capital structure. The value of the levered firm – VL – must be equal to the value of the
unlevered firm. (Figure 2.) VU . (VL=VU=EBIT/WACC=EBIT/KEU)

Figure 2. Modigliani and Miller Proposition I-II. (no tax scenario)
Source: Bélyácz, 1997, 20.p.

MM Proposition II. implies that, the higher the debt-equity ratio, the higher the
expected turn on equity. (RE=RA+(RA-RD)(D/E))
Now let:

RE = the expected return on equity, or the cost of equity
RA= the expected return when the company is all-equity financed

RD= the interest rate, or the cost of debt
D = debt
E = equity

3. Modigliani and Miller Proposition I-II /with taxes/

Of course, in the real world, there are taxes, transaction costs, bankruptcy costs,

differences in borrowing costs, information asymmetries and effects of debt on earnings.
The earnings after interest payments are taxable in the real world. And this is one of the
most important reasons for firms to use debt financing. Modigliani and Miller made a
correction in 1963, when the first imperfection was introduced: corporate taxes
(Modigliani-Miller, 1963).
This proposition recognizes the tax benefit from interest payments – that is, because
interest paid on debt is tax deductible, issuing bonds effectively reduces a company’s tax
liability. Paying dividends on equity, however, does not. Thought of another way, the
actual rate of interest companies pay on the bonds they issue is less than the nominal
rate of interest because of the tax savings (Modigliani-Miller, 1963).

debt

915

MM showed that when corporate taxes are included, the value of the levered firm is equal
to the value of an unlevered firm plus the present value of the tax shields associated by
debt: VL = VU + t*D, where t is the corporate tax rate. In this way the optimal capital
structure that maximizes the value of a firm consists of 100% debt. I illustrate this theory
in Figure 3.
In summary, the MM I theory without corporate taxes says that a firm’s relative proportions
of debt and equity don’t matter; MM I with corporate taxes says that the firm with the
greater proportion of debt is more valuable because of the interest tax shield. In comparing
the two theories, the main difference between them is the potential benefit from debt in a
capital structure, which comes from the tax benefit of the interest payments.

Figure 3: Modigliani and Miller Proposition I-II. (with tax)
Source: Bélyácz, 2001, 537.p.

4. Baxter – Bankruptcy costs

As we have seen, in a world without transactions costs risky debt does not affect on the
value of the firm. When bankruptcy costs are taken into consideration, things are
beginning to look differently.
This third step in capital structure theory was first suggested by Baxter and later modified
by others. In this way, bankcruptcy costs are introduced. Now the value of the firm in
bankruptcy is reduced by the fact that payments must be made to third parties other than
bond- or shareholders. Trustee fees, legal fees, and other costs of reorganization or
bankruptcy are deducted from the net asset value of the bankrupt firm and from the
proceeds that should go to bondholders. (Harvey, 1995)
These “dead weight” losses associated with bankruptcy cause the value of the fim to be
less than it would have been otherwise, namely the value based on the expected cash

916

flows from operations. And since the change of going bankrupt is higher when a firm is
financed with more debt, there are costs involved with debt financing. The tradeoff
between the tax advantage of debt and bankruptcy costs associated with debt results in
an optimal capital structure, the so called balancing theorem (Figure 4.).

Figure 4: The optimal capital structure according to the balancing theorem
Source: Bélyácz, 2001, 537.p.

5. Later developments in the theorems
The next step in capital structure theory was the introduction of personal taxes in 1977.
Miller showed that, again, a “nothing matters” situation arises when you combine
corporate and personal taxes. Since capital gains are not taxed, but interest is taxed at
the personal level, for the investor, who ultimately determines the market value of a
company, there might even be a tax disadvantage to debt financing. (Allen, 1991)
Then in 1976, a new strand of literature was started by Jensen and Meckling. They
introduced the so called agency theory –see Figure 5.- in the world of corporate finance,
which relaxes the assumption of no conflict of interest between different parties, especially
management, shareholders and debtholders. In particular, managers do not always act in
the interest of the shareholders and consequently the goal is not always to maximize the
value of the company. The paper shows that, based on these agency problems and
without assuming taxes or bankruptcy costs, an optimal capital structure can be
explained.

D A

917

Figure 5: Agency theory
Source: Bélyácz, 2001, 504.p.

In 1977 Ross introduced the existence of asymmetric information in capital structure
theory. Assuming that managers have more information about the expected returns of the
company than outside investors, he argued that bigger financial leverage can be used by
managers to signal an optimistic future of the firm. (Fama, 1984)
Since the late seventies, until the late eighties, virtually all research concerning capital
structure issues has been concerned with agency and/or asymmetric informational issues.
Since the middle of the eighties, interrelations between financing and investment
decisions (Titman, 1984) and capital structure choices in relation to takeovers (Harris and
Raviv, 1988) have been studied. In particular, in Harris and Raviv managers are assumed
to want always to continue the firm’s current operations even if liquidation of the firm is
preferred by investors. In Stulz (1990), managers are assumed to want always to invest
all available funds even if paying out cash is better for investors. In both cases, it is
assumed that the conflict cannot be resolved through contracts based on cash flow and
investment expenditure. Debt mitigates the problem in the Harris and Raviv model by
giving investors (debtholders) the option to force liquidation if cash flows are poor. Capital
structure is determined by trading off these benefits of debt against costs of debt. In Harris
and Raviv, the assertion of control by investors through bankruptcy entails costs related
to the production of information, used in the liquidation decision, about the firm’s
prospects. The cost of debt in Stulz’s model is that debt payments may more than exhaust
“free” cash, reducing the funds available for profitable investment.
Diamond (1989) and Hirshleifer and Thakor (1989) show how managers or firms have an
incentive to pursue relatively safe projects out of reputational considerations.
„Diamond’s model is concerned with a firm’s reputation for choosing projects that assure
debt repayment. There are two possible investment projects: a safe, positive NPV project
and a risky, negative NPV project.” (Harris-Raviv, 1988)
The risky project can have one of two payoffs (“success” or “failure”). Both projects require
the same initial investment which must be financed by debt. A firm can be of three, initially
observationally equivalent types. One type has access only to the safe project, one type
has access only to the risky project, and one type has access to both. Since investors
cannot distinguish the firms ex ante, the initial lending rate reflects their beliefs about the
projects chosen by firms on average. Returns from the safe project suffice to pay the
debtholders (even if the firm is believed by investors to have only the risky project), but
returns from the risky project allow repayment only if the project is successful.
And apart from the theoretical literature hundreds of papers try to empirically test all the
different capital structure theories.

D/D+E

918

7. Conclusion

We can see above how many theories exist for defining the optimal capital structure.
Proposition I of MM has become the first step in capital structure theory and it is
sometimes called the ‘irrelevance’ theorem. It states that, as an implication of equilibrium
in perfect capital markets, the value of a firm is independent of its capital structure. The
second step was also made by MM in 1963, when corporate taxes are introduced in the
model, 100% debt financing is optimal. The third step in capital structure theory was first
suggested by Baxter in 1976 and later formalized by others. Now, bankcruptcy costs are
introduced. The tradeoff between the tax advantage of debt and bankruptcy costs
associated with debt results in an optimal capital structure, the so called balancing
theorem.
Despite these theoretical appeals, researchers in financial management have not found
the optimal capital structure.

References

1. Allen, F. and D. Gale, 1991. Arbitrage, Short Sales, and Financial Innovation,
Econometrica 59, 1041-1068.

2. Bélyácz, I.,2001. Investment -Theory. PTE, Pécs 665 pp.
3. Baker, M. and Wurgler, J. (2002): Market Timing and Capital Structure, Journal

of Financial Economics LVII,
4. Diamond, Douglas W., 1989, Reputation acquisition in debt markets, Journal of

Political Economy97, 828–862.
5. Harvey , C. R.,1995 Capital Strucure and Payout Policies, GB.45-68
6. Hirshleifer, David and Anjan V. Thakor, 1989, Managerial reputation, project

choice and debt, Working paper 14–89, Anderson Graduate School of
Management at UCLA.

7. Fama, E.F., 1984, “The Information in the Term Structure,” Journal of Financial
Economics 13, 509-528.

8. Harris, Milton and Artur Raviv, 1988, Corporate control contests and capital
structure, Journal of Financial Economics 20, 55–86.

9. Hovakimian, A., T. Opler, and S. Titman, 2001, “The Debt-Equity Choice,” Journal
of Financial and Quantitative Analysis 36, 1-24.

10. Modigliani, F. and M.H. Miller, 1958, “The Cost of Capital, Corporation Finance,
and the Theory of Investments,” American Economic Review 48, 261-297.

11. Modigliani, F. – Miller, M.H. (1959): The Cost of Capital, Corporation Finance,
and the Theory of Investment: Reply. American Economic Review 49, pp.655-
669

12. Modigliani, F. – Miller,, M.H. (1963): Corporate Income Taxes and the Cost of
Capital: A Correction. American Economic Review 53, pp.433-443

13. Stulz, René, 1990, Managerial discretion and optimal financing policies, Journal
of Financial Economics 26, 3–27.

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TheUSV Annals
of Economics and

Public Administration

Volume 15,
Special Issue,

2015

DIVIDEND POLICY, SIGNAL INFORMATION FOR
THE CAPITAL MARKET

Lecturer PhD Angela Nicoleta COZORICI

‘Stefan cel Mare’ University of Suceava, Romania
angelac@seap.usv.ro

Abstract:
Accumulated profits represent one of the most important sources of financing for companies and dividends

represent cash flows due to holders of shares. The decision on the distribution of dividends to the shareholders,
although it seems very simple at first sight, affect both the investment decision, as well as the financing policy of the
firm because it is a question of choose between dividend distribution and reinvesting a big part of profits, by the
company in question.
The dividend policy of firms is influenced by rules, customs, beliefs, public opinion, general economic conditions and
other factors who are in permanent change with a different impact on the companies. In these circumstances, it can not
be mathematically and uniform modeled for all companies and for all the moments. Thus, the policy adopted by a
company must be in accordance with the degree of shareholders satisfaction and with firm objectives.

Key words: benefit; dividend policy; profitability; reinvestment; shares.

JEL classification: G11, G32, G35

I. INTRODUCTION

Finances are the subject of a policy of business drivers, which is the expression of behavior,
of an election, a tactical or strategic decision to help, in the best measure, the objective to maximize
the value. According to Stancu (1997), financial policy of the company represents a ”set of
decisions, fundamental options for the most efficient allocation of capital”. In relation with the
special notes on financial activity of the enterprise we can identify three financial policies, which
shall be regarded, at the beginning, as independend, which is an integral part of the economic policy
of the business.

Figure no. 1 – Financial policies at enterprise level

Investment policy, as part of the company’s financial policy, address the issue of capital
allocation for physical or financial assets, and between these, the central place returns fixed assets
acquired as a result of the capital investments.

The funding policy is considering decisions on capital formation, including financial funds
of the enterprise. It directly targeting options on using different formation sources of capital and
financial structure of the company.

The USV Annals of Economics and Public Administration Volume 15, Special Issue, 2015

Dividend policy is synthetic materialized through enterprise options between partial or full
reinvestment of net profit, including establishment of other funds or reserves at its disposal and/or
distribution of this profit as dividends to shareholders.

Financial policy cannot be determined once, it grows, changes, is improving and
continuously adapts to the requirements and problems that arise, considering both financial
instruments as well as the aims pursued.

II. EPISTEMOLOGICAL FRAMEWORK OF DIVIDEND POLICY

The profit distribution policy refers to the decision of the general meeting of shareholders to
distribute dividends resulting at the end of the financial year and/or to reinvest in the company’s
development.
If we consider an economic environment characterized by a relative simplicity, the dividend policy
defines the distribution of net profit by destination (for dividends or reinvestment), but with the
development of the economic environment, there were new options so that financial management
must respond to new questions about the decision to distribute cash dividends or buying back
shares, ordinary or special dividend distribution, which is more important: increases in market price
or paid as dividends or how to harmonize views belonging to different classes of investors.
Distribution of dividends complete the image of a profitable company, and constant distribution of
dividends lead to the increase public confidence towards the company, to an increase of market
value of the firm.
Reinvestment of net profits lead to increased self-financing capacity and improve the financial
structure of capital company.
In these circumstances, the company will have a higher financial potential to support their own
development (self-financing and capacity to appeal to new loans), all these factors constituting the
increase of the company.

The alternative to reinvest all or part of the net profit in financing investment projects of the
company is part of the funding policy and for this reason we can say that dividend policy is part of
the funding policy.

Numerous studies on dividend policy requires an epistemological analysis of it. Thus, in the
scientific literature were outlined two models on this concept: one that is based on a set of limiting
assumptions providing a standard in the distribution of dividends and one which emphasizes the
need for distribution of dividends because this is the actual reward

of shareholders. The first type of models belongs to the authors as Miller, Modigliani,
Walter and Bhattacharya, and for the second category we remember on Graham and Dodd.

In the paper Dividend policy, growth, and the valuation of shares, Miller and Modigliani
(1961) proves that in the perfect market conditions, a rational investor will be indifferent between
receiving dividends and reinvesting profits. On the other hand, Brennan (1970) takes into account
the tax differential between reinvested profits and dividends and proposes that the last ones should
not be ever distributed.

Modern theories focuses on informational content of dividends (Bhattacharya, 1979), as
well as on their importance in monitoring the activity of managers by shareholders (Rozeff, 1982;
Easterbrook, 1984).

Dividend policy has a significant influence on the risk of the bankruptcy of a company
because there is a decrease of availabilities which may cover loans when they should be
reimbursed.

Kalay (1982) believes that a decision which is based on the dividend decrease may be a
premise to keep under control a possible decision to increase the indebtedness of the company.
Thus, those companies that have high level of loans will be characterized by a low rate of dividend.

The USV Annals of Economics and Public Administration Volume 15, Special Issue, 2015

III. DETERMINANTS OF DIVIDEND POLICY

The dividend policy of firms constitute a cultural phenomenon, influenced by a variety of
factors in a permanent change, with a different impact on firms. In these circumstances, it cannot be
mathematically and uniform modeled to all firms and for all the moments.

Figure no. 2 – Determinants of dividend policy

Some theories are trying to identify exactly determinants of dividend policy actually applied
on the firms. In this category includes models developed by Lintner (1956) and by the researchers
who developed its theory. They do not attempt to provide the answer to the question “How should it
happen?”, but also tries to offer an answer to the question” why it happens as it actually happens?”.
These theories propose to explain these phenomena not only in mathematical considerations, but
also psychological. Some of the arguments which may be taken into account by such a vision are
given by issues of convenience (investors collect dividends without any effort on their part), by
control of the company (power to vote at general meetings of shareholders) or simply by fashion or
mood (Shiller, 1989).

IV. THEORIES ON DIVIDEND POLICY

In the specialized literature there are a diversity of opinions on the reason why companies
distribute a part of their earnings as dividends. These explanations, which are based on assumptions
more or less restrictive, are trying to create some standard models underlying the dividend policy
and to solve the inherent paradox linked to shareholders remuneration.

In this sense, Graham and Dodd (1951) developed the first theory addressing the
shareholders perception on the distribution of dividends according to which shareholders do not
want higher receipts in the future but effective receipts at present. Thus, they claim the need for
dividends and obtaining receipts at present in the detriment of reinvest the profits which will bring
higher receipts in the future.

Classical theories of dividend policy failed to provide an final and unquestionable
explanation of it, reminding among them neutrality theory of the dividend policy on the company,
necessity theory of dividend distribution and necessity theory of profit reinvestment.

Miller and Modigliani (1961) argues, as we mentioned a little earlier, that dividend policy
would be irrelevant, while Walter (1956) recommends first to achieve attractive investment and the
rest of the profit shall be distributed to shareholders as dividends. In this regard shall be fixed part
of the profit required for investment, and the difference should be distributed as dividend, this
showing us a different approach to dividend, namely residual variable.

Gordon and Shapiro (1956) argue that to maintain the attractiveness of the shares of a
company is required a policy based on constant growth rate of dividends. According to the authors,
share value is given by the relation:

The USV Annals of Economics and Public Administration Volume 15, Special Issue, 2015

Where:
Po = value of shares
D1 = amount of dividends received
Kc = required rate of return
g = dividend growth rate

The main disadvantage of this model refers to the fact that the dividend represents the only
indicator that determines the share value, and the evaluation of a company can be wrong determined
if it is not correctly approximated. In the paper Dividend Policy, the author Victor Dragotă argues
that from a historic point of view, the first theories on dividends arise in connection with the most
obvious pragmatic role of their distribution to shareholders. Thus, we must not forget that, through
dividend, shareholders may recover the capital invested most easily once with the share acquiring.
The need for dividends distribution is explained by three theories, namely:

Figure no. 3 – Theories on dividends distribution necessity

Signal theory is addressed to large companies and argues that through dividend can
anticipate more correctly the company perspectives, therefore it has exclusively an informational
role. A company has the ability to distribute dividends to a certain level only if it has sufficient
financial resources and managers estimates the persistence of these resources in the future. Thus,
large companies should distribute larger amounts as dividends towards smaller companies, to
communicate better performance in the future. Otherwise, the public will have a feeling of
insecurity externalized by reducing demand for the company’s shares and, therefore, by decreasing
the stock market course.

The agent theory claims that dividend role is to monitor the activities of managers or
shareholders. Since they have the power of decision as regards financial resources, they will be able
to orient them not only in the sense of maximizing the market value of the company, but also for the
purpose of personal interests. The decision to distribute dividends makes such managers to give up
of a part of these projects less attractive to the firm, what is constituted as a means of monitoring.

Behavioural theory. Various researchers revealed that market investors may manifest
differently at certain times towards the rational behavior defined by financial theory dictates.
Dividend is acting in this respect as a mean of monitoring the consumption.

If investors would be indifferent toward the two possible ways of remuneration (an increase
in stock market course or dividends), they will find that perfectly substitutable receipts from
dividends and those from the sale of shares. Thus, they may be tempted at certain times to consume
more, by selling shares on the market.

The USV Annals of Economics and Public Administration Volume 15, Special Issue, 2015

In this sense, the dividend acts as a mean of self control for shareholders, limiting their
consumption at the level of amounts received as dividends.

V. THE DIVIDEND POLICY OF FINANCIAL INVESTMENT COMPANIES

The five investment companies were established in 1992 under Law no. 58/1991, as Private
Ownership Funds (FPP). At the time of creation, each company has received in the portfolio 6%
(30% in total) of the shares of all companies in Romania, including that of commercial banks. The
difference of 70% was passed in the administration of the State Property Fund – FPS. In 1996, the
five FPPs were transformed into Financial Investment Companies (SIF), according to Law
133/1996.

The initial share capital of each company has been set up as a result of subscriptions carried
out by Romanian citizens entitled (all citizens who, at that time, they had reached the age of 18) of
ownership certificates and privatization coupons.

Following this process, called ”The Great Privatization”, millions of Romanians, so-called
”cuponari” – have became shareholders at five SIFs, by subscribing famous carnets with ownership
certificates. At establishment, all 5 SIFs were forced by law, as if the shareholders do not raise
dividends, they will automatically receive a number of shares corresponding with the value of
dividends. The situation of dividends offered by the five financial investment companies (SIF)
during the period 2005-2013 is shown in the following table:

Table no. 1. Dividends granted by the 5 SIFs during the period 2005-2013
The

company
(symbol)

SIF Banat
Crisana

SIF1

SIF
Moldova

SIF2

SIF
Transilvania

SIF3

SIF
Muntenia

SIF4

SIF
Oltenia

SIF5 Dividend

2005 0.0500 0,0670 0,0500 0,0600 0.0600
2006 0.0600 0,0630 – 0,0700 0.0700
2007 0.0700 0,0500 0,0375 0,0700 0.0780
2008 0.0300 0,0450 0,0300 0,0400 0.0600
2009 0.0500 0,0600 0,0300 0,0400 0.1600
2010 0.1030 0,0900 0,0300 0,0810 0.0750
2011 0.1000 0,2200 0,1712 0,0810 0.1300
2012 – 0,2400 0,1750 0,1340 0.1300
2013 – 0,0660 – – 0.1600

Source: carried out by the author according to data taken from the http://www.bvb.ro/ and http://www.tradeville.eu/

The first financial investment company that has adopted a ”zero” dividend policy was SIF1
in 2012. Thus, after a long time in which all five SIFs have granted dividends (except SIF 3 which
in 2006 has not granted dividends), in 2013, for the first time since their founding in 1996, three of
the five Financial Investment Companies have not paid dividends to shareholders, namely SIF1,
SIF3 and SIF4. The decision not to grant dividends taken by the 3 SIFs at general meetings of
shareholders held in April 2014 led to a decline in the price of shares on the stock exchange.

The USV Annals of Economics and Public Administration Volume 15, Special Issue, 2015

Figure no. 4 – Shares evolution of 5 Financial Investment Companies

Thus, if we look succinctly at the evolution of share price of the 5 SIFs at Bucharest Stock
Exchange during the period in question we can notice that from March to April 2014 when they
knew already the proposals concerning not granting dividends, the share price traded at the BSE has
been in free fall, to all 5 SIFs, as shown in figure above.

Strategic intent of SIFs management for future business development has to intensify
investment effort based on a optimal ratio between investment policy and dividend policy, aiming
the shareholders satisfaction and ensuring future higher yields of company’s, increasing
attractiveness and liquidity of the shares.

VI. CONCLUSIONS

Enouncement of rational arguments in terms of business practices on dividend policy raised
over time many questions and caused a permanent concern in this respect.

Financial theory considers the dividend policy as an interesting field of study due to
problematic incitements which they provide to scientific research. In conditions of an economic
environment characterized by a relative simplicity, by this term was defined the distribution by
destination of net profit, for dividends or reinvestment.

Together with the development of the economic environment, appears financial
management which aims to answer at new questions about the decision mode; what type of
dividends should be distributed; whether to count more on exchange rate increases than on
dividends payments or how to harmonize different viewpoints of investors.

It can be concluded by the fact that the dividend policy of a company can target the
following purposes:

– retention of shareholders who does not intend to sell shares and which contribute to
strengthening and stability of the company;
– increasing confidence of third parties to the company and its creditworthiness;
– economic and social development of the firm through reinvestment of profit or a part of
it.
The evolution of studies on dividend policy has led to a better coordination of the financial

part of companies, this referring to a good correlation of dividends distribution according on what is
more important for the society.

Thus, to reach a top spot market the company has to make loyal shareholders and to keep
them in order to meet difficulties in the way to the podium.

The USV Annals of Economics and Public Administration Volume 15, Special Issue, 2015

Dividend policy practiced by SIF aims at keeping a balance between shareholders
remuneration by dividend and the need to finance investments from reinvested profits.

VII. ACKNOWLEDGMENT

This paper has been financially supported within the project entitled “Horizon 2020 – The doctor
and Postdoctoral Studies: Promoting the national interest through Excellence, Competitiveness
and Responsibility in the field of Romanian fundamental and Applied Scientific
Research, contract number POSDRU/ 159/ 1.5/S/140106. This project is co-financed by European
Social Fund through sectoral Operational Program for Human Resources Development 2007-
2013. Investing in people!

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The USV Annals of Economics and Public Administration Volume 15, Special Issue, 2015

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