Financial Policies and the Value of the Firm Literature review

Financial Policies and the Value of the Firm - Literature review Example The research identified that the matter of a firm’s dividend policy and its effect on current share prices. The effects of different dividend polices on current share prices based on assumptions of perfect capital markets, rational behaviour on the part of investors and perfect certainty. The assumption of perfect markets means that all traders have equal access to information and transaction costs such as brokerage fees and transfer tax which are normally associated with the sale and purchase of shares are non-existent. Rational behaviour indicates a preference for more instead of less and an indifference to the form that wealth takes – whether it is in the form of cash payments as dividends or increases in the market value of shares. Perfect certainty on the other hand indicates that investors have no doubt in relation to the investment and financial policy of the firm as well as the future levels of profitability of all firms. Stiglitz extends the argument that the f inancial policy of the firm is irrelevant to a multi-period model. The reason for this extension is to give consideration to a wider range of financial policies to include not only a debt to equity ratio but a dividend retention ratio, a debt maturity structure and possibly the holding of securities in other firms. While stressing the importance of financial policy on the value of the firm to students of finance, Stiglitz indicates that ‘if the conditions under which the â€Å"irrelevance† theorems obtain’ are considered to be realistic it results in a reduction in the tools that they require to function effectively. Stiglitz (1974) suggested that it is possible to place the decisions that a firm makes into four groups: i. the way in which investment is financed; ii. the way in which revenue is distributed; iii. the amount that should be invested in any particular projects; and iv. the projects that should be undertaken as well as the techniques that should be em ployed. The first two relates to the firms financial policy while the last two relate to its investment policy. Stiglitz (1974) highlights the fact that there is a relationship between both types of decisions which may not be obvious. Stiglitz (1974) also indicates that two different but still closely related propositions have been confused. While they assert that a firm’s financial policy does not affect its value. The first asserts that the individual does not prefer one financial policy over another and specifically to the debt to equity ratio implying therefore that there is determinate ratio for the economy as a whole while the second indicates that there might be some preference as there may be a determinate debt to equity ratio for the economy as a whole but the financial policy of a particular firm makes no difference. Stiglitz (1974) concludes that the first preposition is stronger because it indicates that the financial structure of the economy and therefore the fir m is irrelevant while the second indicates its irrelevance in relation to the firm only. Stiglitz (1984) points out that the decisions that the firm makes are interrelated and so the decision to increase dividend and still decide to invest would suggest that additional capital needs to be obtained. If a loan is obtained to facilitate the investment then less would be available in the following period and to either retained earnings or dividends would decrease. If instead, shares are issued to facilitate the decision to invest then the amount distributed to shareholders in the following period would decrease if retained earnings is left unchanged. Stiglitz (1974) points to shortcomings in Baumol and Malkiel (1967) and Modigliani and Miller (1958) in their discussion of on how taxation impacts the optimal financial policy of the firm. Baumol and Malkiel (1967) and Modigliani and Miller (1958) observed that debt reduces the amount of tax that a firm is