Dividend Irrelevance

1
Theory
 Miller & Modigliani Hypothesis (MM Approach)

Presented by Muhammad Salman

Roll No. BBAF19M019
Dividend Irrelevance Theory 2

• The propagators of this school of thought were France Modigliani and Merton
Miller (1961).
• They state that the dividend policy employed by a firm does not affect the value
of the firm. They argue that the value of the firm is dependent on the firm’s
earnings which result from its investment policy, such that when the policy is
given the dividend policy is of no consequence.
Assumptions of M-M Hypothesis 3

• Perfect capital markets, i.e. investors behave rationally, information is freely

available to all investors, transaction and floatation costs do not exists, no
investor is large enough to influence the price of a share.
• Taxes do not exist; or there is no difference in the tax rates applicable to both
dividends and capital gains.
• The firm has a fixed investment policy
• The risk of uncertainty does not exist; i.e. all investors are able to forecast future
prices and dividends with certainty and one discount rate is appropriate for all
securities over all time periods.
Assumptions of M-M Hypothesis 4

• Conditions that face a firm operating in a perfect capital market, either;

1. The firm has sufficient funds to pay dividend
2. The firm does not have sufficient funds to pay dividend therefore it issues
stocks in order to finance payment of dividends
3. The firm does not pay dividends but the shareholders need cash
 Illustration No.1 5

The capital structure of a company Ltd. is as follows:

Equity Share capital (Rs. 100 each): Rs. 100 lakhs
Earnings for Equity shareholders: Rs. 10 lakhs
Price of the share in the beginning: Rs. 100
Equity Capitalization Rate: 10%
Required:
(a) Calculate the theoretical market price of equity share under MM Model, if the
company is considering a payout of (i) 0% (ii) 80%
(b) Calculate the value of the firm using MM Model if dividend payout ratio is
(i) 0% (ii) 80%. The company proposes to make a new investment of Rs.
12,20,000.
Solution: 6

EPS = Rs. 10,00,000/1,00,000 = Rs. 10

Market Price under MM Model:
P1=
0% Payout Ratio 80% Payout Ratio

P1= 100 (1+0.1)-0 = 110 P1= 100 (1+0.1)-8 = 102

 Calculation of Value of firm using MM Model 7
Particulars When dividend is not declared When dividend is declared
D1= Dividend per share declared Rs. 0 Rs. 8

P1= P1= 100 (1+0.1)-0 = 110 P1= 100 (1+0.1)-8 = 112

n= No. of old shares 1,00,000 1,00,000
Y= Total earnings for equity shareholders Rs. 10,00,000 Rs. 10,00,000
nD1= Total Dividend declared 1,00,000 x 0 = 0 1,00,000 x 8 = Rs. 8,00,000
Y-nD1= Retained earnings 10,00,000-0= 10,00,000 10,00,000-8,00,000= 2,00,000
I= Investment to be made Rs. 12,20,000 Rs. 12,20,000
E= External financing 12,20,000-10,00,000= 2,20,000 12,20,000-2,00,000= 10,20,000
∆n= No. of shares to be issued 2,20,000/110= 2,000 10,20,000/102= 10,000
n+∆n= Total No. of shares 1,00,000 + 2,000= 1,02,000 1,00,000 + 10,000= 1,10,000
Value of firm= = Rs. 100 lakhs = Rs. 100 lakhs
Conclusion of the Model 8

• A firm which pays dividends will have to raise funds externally in order to
finance its investment plans. When a firm pays dividend therefor, its advantage is
offset by external financing.
• This means that the terminal value of the share declines when dividends are paid.
Thus the wealth of the shareholders - dividends plus the terminal share price –
remains unchanged.
• Thus the shareholders are indifferent between the payment of dividends and
retention of earnings.
 9

The End