HOME ASSIGNMENT

(2018-20)
RELEVENCE OF DIVIDEND AND
MM HYPOTHESIS

Subject: FINANCIAL MANAGEMENT

SUBMITTED BY:
VARONIKA KOUR
ROLL NO. : 68-MBA-18 Sec B
GROUP-04
SUBMITTED TO:
Prof. SAMEER GUPTA
Signature: ____________________

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 Table of Contents
CHAPTER-01 ........................................................................................................................... 3
1. Learning Outcomes ............................................................................................................ 3
2. Introduction ........................................................................................................................ 3
3. Issues in Dividend Policy ................................................................................................... 3
4. Significance of Dividend Payments ................................................................................... 4
5. Why dividends are relevant? .............................................................................................. 5
6. Residual Theory of Dividend Payments............................................................................. 5
7. Forms of Dividend ............................................................................................................. 6
CHAPTER-02 ......................................................................................................................... 11
1. Learning Outcomes .......................................................................................................... 11
2. Introduction on Dividend Relevance................................................................................ 11
3. Walter’s Model ................................................................................................................. 11
3.1 Assumptions of Walter’s Model ............................................................................ 11
3.2 Share valuation using Walter’s Model ................................................................... 12
3.3 Optimal Dividend payout as per Walter’s Model .................................................. 12
3.4 Walter’s Model: Explanation with example .......................................................... 13
3.5 Criticism of Walter’s Model .................................................................................. 14
4. Gordon’s Model ............................................................................................................... 15
4.1 Assumptions of Gordon’s Model ........................................................................... 15
4.2 Optimal Dividend payout as per Walter’s Model .................................................. 15
4.3. Gordon’s Model: Explanation with example ........................................................ 16
4.4. Criticism of Gordon’s Model ................................................................................ 17
CHAPTER-03 ......................................................................................................................... 18
1. Learning Outcomes .......................................................................................................... 18
2. Introduction about Dividend Irrelevance ......................................................................... 18
3. Miller and Modigliani Theory on Dividend (MM Hypothesis) ....................................... 18
3.1. MM Model Assumptions ...................................................................................... 18
3.2. MM Model Explanation ........................................................................................ 20
3.3. Criticism of MM Model ........................................................................................ 21
References ............................................................................................................................... 23

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 CHAPTER-01
1. Learning Outcomes
After studying this chapter we shall be able to
Understand the Importance of Dividend decision in firms
Know the investment behavior of two classes of investors’ - one preferring dividend and the
other preferring capital gains.
Understand Residual theory of Dividends
Explain different forms of Dividends and their bearing on firms

2. Introduction
Dividend is that part of net earnings distributed to the shareholders of firms. Dividend decision is an
important decision which has a bearing on investment and financing decisions of the firm. A firm’s
objective is to maximize shareholder value. Therefore, it is quite a task for the managers to decide about
the right balance between distribution of dividends and retention of earnings so that they are able to
maximize the shareholder value.

3. Issues in Dividend Policy

An investor is concerned about maximizing its return which is in two forms- Capital gains and
Dividends. One class of investors may prefer dividends as it satisfies their need for current gains while
the other investors’ class may prefer future capital gains. The management has to fulfill the desires of
the investors keeping in mind the present investment opportunities available as well as the external
financing conditions in the market.
If the investment opportunities yield higher returns than the cost of raising external equity, it is better
to retain the earnings and reinvest them.
Another issue emerging from the above issue is to decide upon the payout ratio which has to be given
out to the shareholders. Payout ratio is dividend per share over earning per share. It has a significant
bearing on a firm’s value. A high payout ratio will have lesser retention ratio. Retention ratio is defined
as 1 minus payout ratio. And a low payout ratio will lead to higher retention ratio. Again it depends on
the existing investment opportunities available for the firm. High return yielding opportunities require
funds which can be provided by retaining more earnings and paying lesser dividends. Thus, the retained
earnings are churned for the growth of earnings which indirectly results in the capital gains in long run
for the investors and appreciation in share value. A high payout decision indicates emphasis on higher
current dividends and lesser retentions for the firms. The earnings growth may be slow and hence may
lead to lower market value of the share. But again, it might not be true considering the imperfect markets
and uncertainty in future. Increase in share price in future is bit difficult to predict as it is affected by
various factors whereas dividend is a current income.
Therefore, the managers have to strike a chord between dividend, investment and financing decisions.

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4. Significance of Dividend Payments
Some countries charge taxes on dividends to the investor. And there is a cost involved in raising
fresh equity. But still, investors prefer dividends and firms. There is a set of conceivable reasons
and doubtful reasons behind it. The plausible reasons are:

 Investor Preference for Dividends

Theoretically, dividends and capital gains are perfect substitutes in the absence of taxes
and transaction costs on them respectively. But still an investor prefers dividend over
capital gains due to behavioral motives like Self-control and Aversion to Regret.
Investors have an inclination to preserve their capital and spending dividends.
Therefore, dividend payments provide a cushion for self-controlling investors who have
spent-thrift tendencies.
Sometimes, investors psychologically apprehend the consequences of selling stocks
that the stock price may raise after their selling. Hence, this aversion of regretting
propels them to prefer dividend over capital gains.
 Information Signaling
Dividend payments are sought as a signal to the investors about the future prospects of
a company. The market reactions to stock prices vary as per announcements of
dividends. For example, if a firm has a stable dividend policy over a period of time and
it is changed; investors may think that the future prospects of the company are
promising. Basically, the idea is that management instead of announcing about
company’s future prospects can increase or decrease dividends depending on the
situation.
 Clientele Effect
Clientele effect means a set of investors are biased towards a particular type of security
which tends to affect the price of the security as per the situations. Thus, clientele
preferring dividends prefer to invest in companies giving dividends on regular basis. If
there is a sudden downfall in the dividend payout ratio, investors switch to companies
paying high dividends and the price of security will fall. Therefore, the management
should consider the clientele effect too while deciding about the dividend policy of their
companies.
The doubtful reasons behind dividends are as follows:

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  Bird-in-hand fallacy:
Investors are more concerned about the fact that dividends are certain then capital gains
in. And thus dividend paying firms will have higher value as the investors will discount
them at lower rate of required return due to lesser risk associated with such firm. But
this argument is fallacious. An investor can reinvest the dividend earned in the stocks
of the firm having similar characteristics as the stock paying the dividend.
 Temporary Excess cash
In situations when firms have excess cash earned from other activities than operations
like windfall gains they tend to distribute dividends. But they should also foresee the
future opportunities or projects where the funds may be needed. It is advisable to keep
funds for internal growth purposes which will automatically improve the value of the
shares. Raising fresh equity from market is an expensive affair as it involves huge costs
of issue and floatation. So it is better to use retained earnings for future capital
expenditures rather than paying dividends.

5. Why dividends are relevant?

Whether dividend is relevant or not has always been a question in the minds of theorists. It is
argued that dividends are relevant as they affect the value of the firms. The school of thought
supporting that dividend is relevant propagates that a change in the dividend policy will be
followed by a change in the market value of the firm. A high dividend payment firm is
discounted at lower rate of required return due to lesser risk and hence market value of such
firms is high and vice-versa. The theories that support that “dividends are relevant” work on
the premise that dividend decision and investment decision are related.

6. Residual Theory of Dividend Payments

Residual theory of dividend proposes that the investors are indifferent towards dividend
payments. Thus, companies treat retained earnings as a method of financing. Dividend payment
becomes a function of financing decision for the firm.
In such a condition, the firms have to decide whether they should retain earnings or distribute
them in the form of dividends and how much should be distributed. This decision requires that
the firms should be able to foresee the future investment opportunities. If there are abundant
opportunities available, dividend should not be paid. Investments should be financed through
retained earnings than issuing new stock. In scenarios, when no investment prospects exist the
dividend should be paid.

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This means that the firms should have a dividend policy matching these two extreme situations.
If the firms can earn better returns by investing the retained earnings, the investors are happy
to part away with dividends to earn higher capital gains in future. It requires an optimal
dividend policy should be there.
Optimal Dividend Policy is defined as the dividend policy that strikes a balance between
current dividends and future growth and maximizes the firm’s stock price.
It is advised when the dividends are viewed as passive residual firms should adopt a smoothed
residual dividend policy instead of pure residual dividend policy or a fixed residual dividend
policy. A pure residual dividend policy is a policy whereby a firm pays out all sums left after
meeting all charges against earnings, taxation and planned retentions of earnings for capital
expenditure. Under this policy, dividends are likely to fluctuate sharply with variations in
earnings and changes in investment plans.
A fixed dividend payment ratio policy is a dividend policy whereby a corporation establishes
a dividend payout ratio and applies this to earnings (the fraction of earnings paid out as
dividends). This policy ensures that retentions as well as dividends fluctuate with earnings, but
with given investment plans, outside finance will sometimes be required and reserves will be
affected by dividend policy.
A smoothed dividends policy is one designed to produce smoothly growing dividends. With
this policy, dividend payments are unlikely to be changed due to temporary fluctuations in
earnings; instead, the permanence of any change in earnings is assessed before any change is
made to dividends.

7. Forms of Dividend
Usually the dividends are paid in cash. But it can also be paid in kind in the form of equity
shares popularly known as bonus shares.
Cash Dividend
Companies usually pay dividends in cash. It has to plan accordingly when it has to distribute
cash dividends that whether sufficient cash is available, if not, how much funds to be borrowed.
Companies prepare cash budget at the time of dividend payment mostly when a stable policy
is followed. Otherwise, it is really difficult to plan for cash when unstable dividend policy is in
practice.
Moreover, a cash dividend reduces the assets as the company has to pay out of cash account.
And dividends are paid from the reserves account. Hence both the assets and net worth reduces.

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Issue of Bonus shares
Bonus shares are also called Stock dividend. To combat the issue of paying cash dividends,
some firms use the strategy of issuing bonus shares. In issue of bonus shares, existing
shareholders are issued new shares from the free reserves. The shareholder is entitled for these
new shares on pro rata basis. But this has no impact on the dilution of ownership. As it is just
accounting treatment of recapitalization of reserves and surplus and hence net worth of the
company remains unaffected.
There are some reasons why companies prefer issuing bonus shares:
1. Bonus issue of shares brings market price of the share within a popular range for active
trading.
2. Bonus issue increases the number of outstanding shares that means the trading activity
will increase.
3. It increases the size of share capital which boosts the reputation of the company.

4. It helps in conservation of cash which can be employed in profitable investment

opportunities. Thus earnings are retained in the company and on the other hand,
shareholders are satisfied by getting bonus shares. But in India, shares cannot be issued
in lieu of dividend, thus this reason is weak enough to support this reason.
5. In situations of financial difficulties or a contractual constraint to pay the dividends,
bonus issue can become savior to maintain the confidence of the shareholders.
Why do shareholders value issue of bonus shares?
1. Cash dividend is taxed as it is considered as a part of ordinary income for the
shareholders. Taxes on cash dividends are higher than capital gain receipts. Thus, an
investor can sell the bonus shares and incur lesser tax on capital gain receipts keeping
intact the principal shares. Again as per Indian law, tax on capital gains is there while
dividends are tax free. Therefore, bonus issue is not a cup of tea for Indian investors.
2. Shareholders perceive a bonus issue as a healthy sign of company’s financial state.
They expect that the company’s profitability is going to increase and hence the dilution
of earnings on account of additional issue of shares will be offset. Thus, a bonus issue
carries informational content about company’s state of financial affairs.
3. Issue of bonus shares is also viewed from improvement in future dividends by the
shareholders if a company is paying fixed dividend per share. For instance, if a
shareholder is having 50 shares and he got Rs 2 per share as dividend. The total cash at
his disposal is Rs 100. If the company declares 1:1 bonus shares without any change in

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 dividend payout ratio, the cash dividend for the investor will be Rs 200 ((50+50)* Rs
2). Bonus issue helps in increasing the value of the company by preserving the cash to
be used for future investment projects.
Table 1: Effect of Bonus shares on the balance sheet
Before Bonus Issue Amount (Rs)
Equity share capital (10000 shares of Rs 20 each) 200000
Reserves and Surplus 300000
Total Net worth 500000
After Bonus Issue of 1:2
Equity share capital (15000 shares of Rs 20 each) 300000
Reserves and Surplus 200000
Total Net worth 500000
The above example clearly shows the effect of bonus shares is only felt on reserves and surplus
and an increase in paid up capital.

Issue of bonus shares suffers from some limitations too. Firstly, there is no effect on
shareholders’ wealth. It’s merely an adjustment of past earnings and increase in the number of
share certificates. It does not give additional benefits to the shareholders as the earnings are
just being distributed to the same set of investors but with wider increase in paid up capital as
the ownership is proportional.
Also the issue of bonus shares calls for printing new share certificates which have to be printed
and posted to the shareholders. Thus, it is costly to administer the bonus issue.
When a company has a tendency to announce small bonus issues frequently, it is not easy to
capture the growth in earnings per share as the investment analysts discount the significant
bonus issues.
Regulations for bonus Issue of shares
The bonus issues are governed by following regulations:
1. The bonus issue has to be made out of free reserves made from actual profits or share
premium received in cash only.
2. A bonus issue cannot be done in lieu of cash dividend payment.
3. A bonus issue cannot be done on partly paid up shares.
4. A company should attend to servicing of fixed deposits, debentures and other statutory
dues before bonus issue of shares.
5. A bonus issue should be authorized by the articles of association.

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Stock splits
Before understanding share buyback, we will first understand the concept of stock splits. Stock
split is similar to bonus issues. The only difference is that the number of shares is increased
through a proportional reduction in the par value of the stock.
There are some differences in accounting point of view but the economic effect is same i.e. to
increase the number of outstanding shares. The following comparison can explain a stock split
in a better fashion.
Bonus Issue Stock Split
The par value of the share remains unchanged The par value of the share is reduced.
There is a recapitalization of free reserves and There is no recapitalization of free reserves
surplus. and surplus.
The proportional ownership of the The proportional ownership of the
shareholders remains same. shareholders remains same.
The book value per share, the earnings per The book value per share, the earnings per
share and the market price per share decline. share and the market price per share decline.

The market price per share is brought within a The market price per share is brought within a
popular trading range. popular trading range.

Table 2: Effect of Stock split on the balance sheet

Before Stock Split Amount (Rs)
Equity share capital (10000 shares of Rs 20 each) 200000
Reserves and Surplus 300000
Total Net worth 500000
After Stock Split of 1:1
Equity share capital (20000 shares of Rs 10 each) 200000
Reserves and Surplus 300000
Total Net worth 500000

Share Buybacks
Share buybacks or share repurchase is a transaction in which a firm buys back shares of its own
stock, thereby decreasing outstanding shares, increasing EPS and often increasing the stock
price. Stock repurchase has been permitted in 1998 in India and companies do take advantage
of this programme. The shares bought under this scheme are known as treasury stock.

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The idea is if the firms don’t have sufficient investment opportunities in future, the surplus
funds can be distributed to the shareholders either in the form of share repurchase or dividend
payments. In theory, we assume that the personal income taxes (on dividends) and transaction
costs (on selling and buying of shares) are absent. Therefore, the investor will be indifferent to
both the alternatives of distribution of earnings. A share repurchase will decrease the number
of outstanding shares which will in turn increase the earning per share and dividend per share.
The market price will increase following the suit. Therefore, the appreciation in market price
will be equal to the dividend to be received. This can be understood through the following
example:
ABC Corporation has 10 million shares currently trading at a market price of Rs 45.45. The
company is expecting that it will earn Rs 100 million as Profit after Tax. It plans to distribute
the same at 50% in form of dividends i.e. 50 million. On the other hand, it is also contemplating
to repurchase shares of 1 million at Rs 50.49. The effect can be analyzed as follows:
Current EPS = Rs 100 million/10 million = Rs 10
Current DPS = Rs 50 million/10 million = Rs 5
Price Earnings Ratio = Rs 45.45/ Rs 10 = 4.54

EPS after repurchase of shares = Rs 100 million/9 million = Rs 11.11

DPS after repurchase of shares = Rs 50 million/9 million = Rs 5.55
Market price post repurchase = 4.54* 11.11 = Rs 50.49
The investors end up earning Rs 5 in both the cases- Share repurchase by an appreciation in
market price and cash dividend payment.
The share repurchase is done through two ways- Tender offers and Open Market options.
Share repurchases have their own benefits and drawbacks. The buying shareholders get
benefitted on account of higher price than the current market price of the share. The promoters
of the company get benefits by consolidating their control. Though EPS increases, it helps in
improving the undervalued market share. It is a helpful strategy in times of hostile takeover as
it reduces the number of shares available making takeover difficult.
Share repurchases may indicate that the companies don’t have sufficient investment
opportunities to use cash. Shareholders prefer dividend more than a share repurchase
arrangement. The shareholders who don’t exercise repurchase option are at losing end if the
company pays excessively higher price than the market price.

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 CHAPTER-02
1. Learning Outcomes
After studying this module, we shall be able to:
Understand Walter’s Model for relevance of Dividends.
Explain Gordon’s Model for relevance of Dividends.
Analyze the effect of change in dividend payout on market price.
Determine optimal dividend payout for different types of firms.

2. Introduction on Dividend Relevance

We studied in the last module about the relevance of dividends. Let us recapitulate the same.
The dividend relevance works on the premise that current cash dividends reduces uncertainty
for the investor, hence he discounts the firm’s earnings at a lower rate of required return and
thus, the firm enjoys higher market price of its shares. Similarly, a firm paying lesser dividends
will be considered risky which will increase its lower rate of required return and therefore, the
market value of the firm will be low. It means a firm should pay dividends to the shareholders
to maintain or increase its share price. There are two models on dividend relevance namely
Walter Model and Gordon Model. These models assume that investment and dividend
decisions are related.

3. Walter’s Model
Professor James E. Walter proposed a model on dividend relevance based on the argument that
choice of dividend policies affects the value of the firm. This model is one of the earlier
theoretical works. It tries to establish a relationship between firm’s cost of capital, k, firm’s
required rate of return, r with the market value, P i.e. it tries to find out the dividend policy
which will maximize the wealth of the shareholders.

3.1 Assumptions of Walter’s Model

Walter’s Model is based on certain assumptions discussed below:
# Internal Financing: The firm uses retained earnings for all the investments. It doesn’t issue
fresh capital.
# Constant return and cost of capital: The firm’s required rate of return on investments, r
and the cost of capital, k, are constant.
# No Taxes
# Infinite life/Perpetual life: It is assumed that the firm has an infinite life.

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The idea is that the investment and dividend decisions are related to each other in the sense that
enough profitable opportunities exist, and hence, the firms should not distribute dividends.

3.2 Share valuation using Walter’s Model

As per Walter’s model the following formula is used for share valuation:
P = D + (E - D) r/k
k
Where P = Price per equity share
D = Dividend per share
E = Earnings per share
(E- D) = Retained earnings per share
r = Rate of return on investments
k = Cost of capital
This formula can be divided into two components as given below:
P = D + (E-D) r/k
k k
Here, the first part is the present value of an infinite stream of dividends while the second part
is the present value of an infinite stream of returns on investments made from retained earnings.
Therefore, the market value of the share is the sum of expected dividends and capital gains.

3.3 Optimal Dividend payout as per Walter’s Model

The optimal dividend payout ratio is one which maximizes share price of a firm. The optimal
dividend payout as per Walter’s model is based on the type of the firm viz. Growth firm,
Normal firm or Declining firm as explained below.
# Growth Firms: These firms have ample investment opportunities in hand and their rate of
growth is very fast. Their return on investment (r) is higher than the cost of capital (k). Firms
reinvest their retained earnings at higher rates of return and get better returns for them.
Therefore, they will reap more benefits out of retaining their earnings and having a better
market share price. Hence, for such firms the optimal dividend payout ratio is zero payout ratio.
This generates maximum share price.
# Normal Firms: These firms have achieved their threshold of investment opportunities i.e.
they don’t have sufficient profitable opportunities which can yield them rate of return higher
than the cost of capital. Thereby, their return on investment (r) is equal to the cost of their
capital (k). In such situations, the dividend policy will not make any difference to such firms
as the market value of the share is not affected any kind of dividend policy.

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# Declining Firms: These firms don’t have any profitable investment projects to invest their
retained earnings as the rate of required return(r) is lower than the cost of capital (k). In such
situations, firms don’t need to retain any of the earnings rather it should be distributed to the
shareholders which can invested by them at better rate of returns. Hence, for a declining firm
the optimal dividend payout ratio is 100%. At this payout ratio the market price of the share is
maximum. Therefore, we can conclude the following about the Walter’s Model:
 If r>k, the firm should have zero payout and make investments.

 If r=k, the firm is indifferent between dividends and investments.

 If r<k, the firm should have 100% payouts and no investment of retained earnings.

3.4 Walter’s Model: Explanation with example

The Walter’s Model can be explained by following example. This model has been applied on
all three types of the firms- Growth firms, Normal firms and Declining firms.
1. Share valuation in case of Growth Firm where r > k
r = 20 percent
k = 16 per cent
E = Rs 5
Payout ratio = 0%
P = 0 + (5-0) *0.20/0.16 = Rs 39.06
0.16
If payout ratio 40%
P = 2 + (5-2)* 0.20/0.16 = Rs 35.94
0.16
If payout ratio 100%
P = 5+ (5-5)* 0.20/0.16 = Rs 31.25
0.16

2. Share valuation in case of Normal Firm where r = k

r = 16 percent
k = 16 per cent
E = Rs 5
Payout ratio = 0%
P = 0 + (5 - 0) *0.16/0.16 = Rs 31.25
0.16
If Payout ratio = 40%
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P = 2 + (5 - 2)* 0.16/0.16 = Rs 31.25
0.16
If Payout ratio = 100%
P = 5 + (5 - 5)* 0.16/0.16 = Rs 31.25
0.16
3. Share valuation in case of Declining Firm r < k
r = 10 percent
k = 16 per cent
E = Rs 5
If payout ratio is 0%
P = 0 + (5) *0.10/0.16 = Rs 19.53
0.16
If payout ratio is 40%
P = 2 + (5 - 2)* 0.10/0.16 = Rs 24.22
0.16
If payout ratio is 100%
P = 5 + (5 - 5)* 0.10/0.16 = Rs 35.16
0.16

3.5 Criticism of Walter’s Model

Walter’s Model is useful but its assumptions don’t hold true in real life. The following is the
critical examination of the model:
# No external financing: This assumption will not be applicable in real world where firms
have to resort external financing for meeting capital needs. Moreover, by following this
assumption, the firm will not be able to reap the advantages of optimum capital structure. This
assumption will only apply in cases where pure equity financing is done by equity or firms
which don’t follow a debt equity norm.
# Constant Return, r: This model assumes that the required rate of return is constant. This
assumption again does not hold true in real world. The profitable projects enjoy higher rate of
returns. But as more and more investments are being undertaken the profitability of the projects
reduces. Firms will make investments till the time; required rate of return is equal to cost of
capital. Profitability is a matter of various factors.

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# Constant Opportunity Cost of capital, k: The cost of capital is a function of firm’s
riskiness. The higher the risk of the firm, the higher the expectations of the investors and they
will discount firm’s earnings at a higher rate and thus, this would affect the share price.

4. Gordon’s Model
Myron Gordon also proposed a model on dividend relevance that the market value gets affected
by dividend policy. He suggested the following formula for share valuation:
P0 = E1 (1-b)
k –br
where P0 = Price per share at the end of year 0
E1 = Earnings per share at the end of year 1
(1-b) = Fraction of earnings the firm distributes by way of dividends. This is dividend payout
ratio.
b = fraction of earnings the firms ploughs back. Also known as the retention ratio.
k = rate of return required by the shareholders
r = rate of return earned on investments made by the firm

br = growth rate of earnings and dividends

4.1 Assumptions of Gordon’s Model

The model is based on following assumptions
# No external financing: The firm uses retained earnings for all the investments. It doesn’t
issue fresh capital. Thus, like Walter’s model, the investment decision and dividend decision
are related.
# Constant return and cost of capital: The firm’s required rate of return on investments, r
and the cost of capital, k, are constant.
# Perpetual earnings: The firm has an infinite life. Therefore, its earnings are also perpetual.
# No taxes: Taxes do not exist.
# Constant retention: The retention ratio, b, once decided is constant. Growth rate, g = br
# Cost of capital greater than growth rate: The cost of capital, k is greater than the growth
rate, g.

4.2 Optimal Dividend payout as per Walter’s Model

The optimal dividend payout ratio is one which maximizes share price of a firm. The optimal
dividend payout as per Gordon’s model is based on the type of the firm viz. Growth firm,
Normal firm or Declining firm as explained below.

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~ Growth Firm: It can be understood that when rate of return, r is greater than cost of capital,
k, the price per share increases with a decrease in dividend payout. The logic is that the firm
can invest the retained earnings rather than distributing the dividends or decreasing the
dividend payout so that the future share price is maximized.
~ Normal Firm: When the rate of return, r is equal to cost of capital, k, the market price of the
share is indifferent to variations in dividend payout. Here, the rate of return on investment
projects available to the firms is equal to the cost of capital of the same. Therefore, distribution
of dividends is treated same as retaining the earnings.
~ Declining Firm: When the rate of return, r, is lesser than the cost of capital, k, the share price
increases with an increase in dividend payout. In such a situation, the firms don’t have
sufficient number of profitable projects; hence they prefer they should distribute earnings in
the form of dividends to the shareholders rather than investing in projects yielding lesser returns
than the cost of capital. The shareholders can reinvest the dividends to get good returns.

Therefore, we can conclude:

~ For a growth firm(r > k), the optimum payout ratio is nil.
~ The payout ratio does not matter for a normal firm (r = k).
~ For a declining firm, (r < k), the optimum payout ratio is 100 percent.

4.3. Gordon’s Model: Explanation with example

The model will be explained using the same example which we adopted for Walter’s Model.
1. Growth Firm where r > k
r = 20 percent
k = 16 per cent
E = Rs 5
If payout ratio 40%
g = b*r =0.60*0.20= 0.12
P = 5(1- 0.6) = Rs 50
0.16- 0.12
If payout ratio 90%
g = b*r = 0.10*0.20 =0.02
P = 5(1-0.1) = Rs 32.14
0.16- 0.02
2. Share valuation in case of Normal Firm where r = k
r = 16 percent

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k = 16 per cent
E = Rs 5
Payout ratio = 40%
g = b*r = 0.6*0.16= 0.096
P = 5(1-0.6) = Rs 31.25
0.16-0.096
If Payout ratio = 90%

g = b*r = 0.1*0.16 =0.016

P = 5 (1-0.1) = Rs 31.25
0.16- 0.016
3. Share valuation in case of Declining Firm r < k
r = 10 percent
k = 16 per cent
E = Rs 5
If payout ratio is 40%
g =b*r = 0.6*0.10= 0.06
P = 5 (1- 0.6) = Rs 20
0.16-0.06
If payout ratio is 90%
g = b*r = 0.10*0.10 =0.01
P = 5 (1-0.1) = Rs 30
0.16-0.01
If payout ratio is 100%
P = 5 + (5 - 5)* 0.10/0.16 = Rs 35.16
0.16

4.4. Criticism of Gordon’s Model

The criticism of the Gordon’s Model is same as Walter’s model due to same assumptions.
Thus, both the models discussed above focus on the point that the “market value of a firm gets
affected by investment and dividend policy.”

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 CHAPTER-03
1. Learning Outcomes
After studying this module, you will be able to
Understand the idea behind irrelevance of dividends
Explain Miller- Modigliani theory on irrelevance of dividends
Explain various assumptions of MM theory.
Know that the market value of a firm is independent of its dividend policy.

2. Introduction about Dividend Irrelevance

Dividend Irrelevance means that dividend is not relevant as the investors are only interested in
the returns they receive whether they receive in the form of dividends or capital gains. It is the
earning power which decides the market value of the firm. That implies that dividend policy
has no role to affect the company’s share price anyway. A theory has been propounded by two
economists Miller and Modigliani to support this view. Their view referred to as the MM
“dividend relevance” theorem is presented in their 1961 article.

3. Miller and Modigliani Theory on Dividend (MM Hypothesis)

Miller and Modigliani (MM) proposed the view that the dividend policy has no effect on the
share price and hence, no effect on market value of a firm. They suggested that the share value
is the function of the firm’s investment decision. The value of the firm increases on account of
increase in earnings rather than the way the earnings are being distributed between dividends
and retained earnings.
MM argued that the earnings can be distributed as dividends as well as can be retained. If a
firm retains all the earnings instead of distributing the dividends then the shareholder will enjoy
the capital appreciation earned by investing the retained earnings. On the other hand, if a firm
distributes all the earnings, the shareholders will get the dividends beforehand equal to capital
appreciation which could have been derived from retained earnings.

3.1. MM Model Assumptions

MM’s hypothesis is based on following assumptions:
1. Perfect capital markets in which all the investors are rational. The information is
available to all with no cost involved. There are no transactions costs involved.
Securities are infinitely divisible. No investor is large enough to influence the market
price of securities. There are no floatation costs.
2. There are no taxes involved on dividends as well as capital gains.

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 3. A firm’s investment policy is fixed. Therefore, there is no change in a firm’s required
rate of return.
4. There is a perfect certainty by the investors in regard to future investments and profits
of the firm. Therefore, the investors can forecast the future prices and dividends with
certainty. A single discount rate is applicable for all the securities and in all time periods.
Therefore, r =k = kt for all t. (This assumption was dropped later)
The working of the above model can be illustrated through the example discussed below:

ABC Company Ltd. has 3 crore equity shares in their books. The market price of the share is
Rs 100. Company has no debt in its capital structure. The internal accruals for capital
expenditure projects available to the firm are Rs 60 crore. This investment will earn the
company NPV of Rs 30 crore. The company also intends to pay a dividend of Rs 20 per share.
The company wants to spend on capital investment as well as wants to pay dividends. Let’s see
how the firm’s value be affected in two of the scenarios:
i. If firm does not pay any dividend
Current market value of the firm = 3* 100 = Rs 300 crore
After Capital investment = 300 + 30 = Rs 330 Crore
If dividend is not paid, value per share = 330/3= Rs 110
ii. If firm pays dividend
Dividend paid = Rs 60 crore
Value of the share after dividend payment = 110-20 = Rs 90
The firm will raise funds of Rs 60 crore for capital expenditure.
Therefore, the number of shares issued = 60crore/90 = 6666667 shares
The total number of shares after new issue = 36666667
Market value = 36666667*90 = Rs 330 crore
In both the situations, the market value of the firm remains same. The investor earns in all the
scenarios. When the firms does not pay dividend, the market value of the share is Rs 110
whereas when dividends are paid, the market value is Rs 90 i.e. capital loss of Rs 20 which is
compensated by dividend payment of Rs 20.
We can infer the following from the above example:
 If the firm has sufficient cash to pay dividends. The firm parts away with cash to be
given to shareholders but on the other hand, the shareholders will lose their claim on
the reduced assets as there is a transfer from one pocket to another. Hence, there is no
effect on the wealth.

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  In case firm doesn’t have sufficient funds to pay dividends, it will borrow funds.
Therefore, there will be a reduction in the market value due to dividend payment.
 If the company is not paying dividends, the shareholders resort to homemade dividend
by selling a part of their shares and will get cash. The result is that his shareholding is
transferred to the shareholders who have bought the shares. The number of shares for
the firm remains same and hence the value of the firm remains same.
Thus, dividend payment is not relevant as the market value remains same in both the situations.

3.2. MM Model Explanation

We can derive the valuation model to test MM hypothesis from the equation given below:

P0 = DIV1 + P1........................................................................................................ (1)

(1 + k)
Multiplying both sides by ‘n’, number of shares outstanding in case the firm is not issuing new
shares, the resultant equation is:
V = nP0 =n (DIV1 + P1) …………………………………………………………… (2)
(1 + k)
If the firm sells m number of shares at time 1 at a price of P1, the value of the firm at time 0
will be:
nP0 = n(DIV1 + P1) + mP1 – mP1
(1 +k)
= nDIV1 + nP1 + mP1 – mP1
(1 +k)
= nDIV1 + (n+ m)P1 – mP1………………………………………………….(3)
(1 +k)
The above equation clearly shows that the firms can pay dividends and raise funds to undertake
investment policy.
The investments of the firms can be financed either through retained earnings or issue of new
shares or combination of both. Thus, the amount of new shares issued will be:
mP1 = I1 – (X1 – nDIV1)
= I1 – X1 +nDIV1…………………………………………………………….(4)
whereI1= Total investment during the first period
X1 = Total net profit of the firm during first period
Thus, replacing equation (5) into equation (4), MM showed that the value of the firm is
unaffected by its dividend policy. Thus,

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nP0 = n(DIV1 + P1) + mP1 – mP1
(1 +k)
= nDIV1 + (n+m) P1 – (I1 – X1 + nDIV1)
(1 +k)
= (n + m) P1–I1 + X1……………………………………… (5)
(1 + k)

From the above equation, it is evident that the dividend policy does not affect the wealth of the
shareholders. The reason is that when the firms pay dividends, it can raise funds externally to
finance its investment projects.

3.3. Criticism of MM Model

MM hypothesis of dividend irrelevance is based on simple assumptions. But in real world,
markets are not perfect due to presence of transaction costs; different types of taxes on capital
gains and dividends. There might be differences in the perceptions of minds of the investors
towards dividends and capital gains. In the following situations, MM hypothesis faces
criticism:
 Information about company’s prospects: Dividend payments may carry information
about the company’s prospects. A high dividend payout may suggest that the future of
the company is bright whereas a low dividend payout may suggest uncertainty about
the future of the financial prospects of the company. Gordon even supported this view
in his theory. Dividends remove uncertainty for the investors. High dividend paying
shares command higher price in the market. MM supports that the dividends are the
alternative for future earnings anticipated in future for the valuation of the firm.

 Uncertainty and Fluctuations: Stock market returns are uncertain on account of

various factors- systematic and unsystematic. Therefore, uncertainty may make a
shareholder prefer for present earnings in the forms of dividends. Future incomes are
discounted at a higher rate of return due to uncertainty. Thus, dividend paying firms
command higher price than those not paying dividends. Also some investors are fond
of enjoying current incomes due to various reasons like sense of security and preference
for current income. Therefore, such factors make dividend payments relevant.

 Transactions costs: MM Model assumes there are no transaction costs. Transaction

costs are the costs are the expenses incurred on buying or selling the securities. If

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 transaction costs are absent, capital gains and dividends are treated at par by the
investor. Therefore, if an investor is in need of current income or in case the dividend
amount received by him is lesser than his need; he can sell some of his shares without
incurring any transaction costs and vice-versa. But in real world, the transaction costs
are there and hence dividend income is not equal to capital gain. A capital gain will be
an amount deducted of transaction costs. Therefore, to save on such costs, an investor
with higher appetite for current income prefers companies paying higher dividends.

 Different rates of Taxes: As per MM model, there are no taxes on dividends and capital
gains. In reality, there are taxes on both the incomes. In India, there are no taxes on
dividends for the shareholders but capital gain tax is charged at 15% if the shares are
sold less than a time span of one year. Therefore, a shareholder preferring current
income will prefer dividends rather than selling the shares.

 Issuance cost on raising additional capital: MM model assumes the firms can raise
additional capital whenever they pay dividends without incurring any costs on issue of
the securities known as floatation costs. Floatation costs include expenses such as
underwriting fees, legal fees and registration fees. They depend on the size of the issue.
Higher the issue size, lower the floatation costs. Thus, the firms cannot raise additional
equity in lieu of frequent dividend payments as dividend payments are smaller sums.
 Additional Equity at Current Market Price: MM model makes the assumption that the
additional shares can be issued at the existing current market price. While in the real world, the
companies have to depend on the advice of the merchant bankers to devise a market price which
is mostly lower than the current market price.
 Rationing of the Investments projects: In MM model, it is assumed that the firms invest in
those projects whereby the rate of returns earned is equal to the cost of capital. Also it means
that the investment policy is not dependent on the financing policy. In practice, the firms don’t
buy this premise due to various reasons. Sometimes, firms are not able to raise money for their
investments due to difficult market conditions or riskiness of the firms. Sometimes, firms are
interested in parting profits to the investors in the form of dividends. Therefore, dividends
become relevant.

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 References
https://nptel.ac.in/courses/105103023/39

https://www.scribd.com/doc/15880531/FINANCIAL-MANAGEMENT-Notes

https://www.iare.ac.in/sites/default/files/...notes/IARE_FM_Lecture%20_Notes_2.pdf

https://www.slideshare.net/niaz007/financial-management-complete-note-for-bba

www.businessmanagementideas.com/notes/financial-management-notes/

Financial Management by IM Pandey

Financial management- text and problems by M.Y. Khan, PK Jain

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