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APPROACH

( MM Approach)

Modigliani and Miller Approach (MM model)

• They maintain that dividend policy has no effect

on the market price of the shares and the value of

the firm is determined by the earning capacity of

the firm or the investment policy .

• As observed by M.M ,Under condition of perfect

capital markets , rational investors , absence of

tax discrimination between dividend income and

capital appreciation , given the firm’s investment

policy , its dividend policy may have no influence

on market price of the share.

It is argued that dividend policy has no effect on the

market price of the shares and the value of the form is

determined by the earning capacity of the firm or the

investment policy

Argument of MM approach?

ASSUMPTIONS

• The capital markets are perfect and the investors

behave rationally.

• All information is freely available to all the investors.

• There is no transaction cost and time lag

• Securities are divisible and can be split into any

fraction. No investor can affect the market price.

• There are no taxes and no flotation cost.

• The firm has a defined investment policy and the

future profits are known with certainty. The implication

is that the investment decisions are unaffected by the

dividend decision and the operating cash flows are

same no matter which dividend policy is adopted.

Mathematical Expression

Where, po= Present market price of the share.

D1= Expected dividend at the end of year 1.

p1=Expected market price of the share at the

end of year 1.

ke = cost of equity capital.

EXAMPLE

A firm has 1,00,000 shares outstanding and is planning to declare a dividend of Rs. 5

at the end of the current financial year. The present market price of the share is Rs.

100. The cost of equity capital, ke, may be taken at 10%. The expected market price

at the end of the year 1 may be found under two options: (i) if dividend of Rs. 5 is

paid, and (ii) if the dividend is not paid.

When Dividend of Rs.5 is paid (the value of D1 is 5) :

P0 = (D1 + P1)/ (1+ ke)

P0 (1+ ke) = D1 + P1

P1 = P0 (1+ ke) – D1

= 100(1.10) – 5

= 105

So, the market price is expected to be Rs.105, if the firm pays

dividend of Rs.5

When, Dividend of Rs.5 is not paid (the value of D1 is 0):

P0 = (D1 + P1)/ (1+ ke)

P0 (1+ ke) = D1 + P1

P1 = P0(1+ ke) – D1

= 100(1.1)

= 110

So, the market price of the share is expected to be Rs.110, if

the firm does not pay any dividend.

nP0 = [(n + m)P1 – I +E] / (1+ ke)

Formula to calculate the Value of the firm

Where, nP0 = value of the firm

n = number of equity shares outstanding

m = number of equity shares at price P1

P1= Expected market price of the share at the end of year 1

I = total investment to be made at year 1

E = total earnings of the firm

The same example can be extended further to analyze the effect of arbitrage

employed by the firm.

The firm has total profits of Rs.1000000 during the year 1 and is planning to make

an investment of Rs.2000000 at the end of the year 1. The arbitrage process and

value of the firm may be explained as follows:

If dividend of Rs.5 is paid by the firm at the end of year 1: (Rs.)

Total Earnings 10,00,000

(-)Dividends Paid (100000 * Rs.5) 5,00,000

Retained Earnings 5,00,000

Total funds required for investment 20,00,000

Therefore, fresh capital to be issued 15,00,000

Market price at the end of year 1 105

Number of shares to be issued (Rs.15,00,000/105) 14,285.71

Total number of shares (100000+14285.71) 1,14,285.71

Applying the formula, the value of the firm, nP0 is

nP0 = [(n + m)P1 – I +E] / (1+ ke)

= [(114285.71)105 – 20,00,000 + 10,00,000] / (1.10)

= Rs.1,00,00,000

If dividend of Rs.5 is not paid by the firm at the end of the year 1: (Rs.)

Total earnings 10,00,000

(-)Dividends Paid -

Retained Earnings 10,00,000

Total funds required for investment 20,00,000

Therefore, fresh capital to be issued 10,00,000

Market price at the end of year 1 110

Number of share to be issued (1000000/110) 9090.9

Total number of shares (100000+9090.0) 1,09,090.9

Applying the formula, the value of the firm, nP0 is

nP0 = [(n + m) P1 – I +E] / (1+ ke)

= [(109090.9)110 – 20,00,000 + 10,00,000]

= Rs.1,00,00,000

So, the value of the firm remains same at Rs.10000000 if the dividend is paid or not.

With the help of above process, it can be showed that dividend policy is irrelevant for

the valuation of the firm. Dividend payment does not affect the value of the firm.

It should be noted that, the formula used above, gives the current market value of the

firm. The MM model shows that if dividend is paid or not at the end of current year, the

present market value of the firm remains same at Rs.1,00,00,000. The same example

can be applied to find out the expected market value of the firm at the end of current

year as follows:

· If dividend of Rs.5 is paid

Total number of shares 1,14,285.71

Market price Rs.105

Total market value (114285.71*105) Rs.1,20,00,000

· If dividend of Rs.5 is not paid

Total number of shares 109090.90

Market price Rs.110

Total market value (109090.90*110) Rs.1,20,00,000

Thus, the expected market value remains same at Rs.1,20,00,000, whether the firm pays

dividend of Rs.5 or not. The MM Model shows therefore, that the current market value

or the expected market value of the firm, both are unaffected by the dividend decision

of the firm.

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