Page 225 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes K = The cost of equity capital
e
D = the dividend to be paid at the end of the period one
1
P = The market price of a share at the end of period one with no external
1
financing the total value of the firm will be as follows:
1
nP = (nD + nP ) ….. (2)
1
1
+
0 (1 K )
e
where, n = No. of shares outstanding
Now, if the firm finances its investment decisions by raising additional capital issuing n1 new
shares at the end of the period (t = 1), then the capitalized value of the firm will be the sum of the
dividends received at the end of the period and the value of the total outstanding shares at the
end of the period less the value of the new shares. Since this adjustment is actually adding and
reducing the value of the new shares. Thus we have:
1
nP = [nD + ( n + n) P – n P ] …. (3)
0 1 1 1 1
(1 + K e )
Firms will have to revise additional capital to fund its investment requirement, if its investment
requirement is more than its retained earnings, additional equity capital (n P ) after utilizing its
1 1
retained earnings will be as follows:
n P = I – (E – nD ) …. (4)
1 1 1
where, I = Total investment required
nD = Total dividends paid
1
E = Earnings during the period
(E–nD ) = retained earnings
1
Simplifying the above equation we get,
N P = I – E + nD …. (5)
1 1 1
Substitute the value of the new shares in equation (3) we get
1
nP = [nD + ( n + n) P – 1 + E – nD )]
0 1 1 1 1
(1 + K e )
nD + (n + 1 n ) P – 1 + E–nD 1
1
1
=
1 + e k
(n + n ) P – 1 + E
1
1
= …. (6)
(1 + e k )
[Since the positive nD , and negative nD cancels]
1 1
Since dividends (D) are not found in equation (6), MM concludes that dividends do not count and
that dividend policy has no effect on share price.
Let us take an example to explain MM theory:

Example: The capitalization rate of A Ltd. is 12%. The company has outstanding shares to
the extent of 25,000 shares selling @ 100 each. Assume, the net income anticipated for the
current financial year of 3,50,000. A Ltd. plans to declare a dividend of 3 per share. The
company has investment plans for new project of 500,000. Show that under the MM Model, the
dividend payment does not affect the value of the firm.

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