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Financial Management

Notes The intrinsic value increases from 12 to 16.67 when the payout ratio is raised from 30% to
100%.

14.3.4 Miller and Modigliani Model

The irrelevance of dividends is provided by the MM Hypothesis. MM maintains that dividend
policy has no effect on the share prices of the firm. What matters, according to them, is the
investment policy through which the firm can increase its earnings and thereby the value of the
firm given the investment decision of the firm, the dividend decision – splitting the earnings
into packages of retentions and dividends – is a matter of detail and does not matter.
Under conditions 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 the market price of shares.

Assumptions

MM Hypothesis is based on the following critical assumptions:

1. Perfect capital markets, in which all investors are rational. Information is available to all
free of cost, there are no transaction costs, 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. Alternatively, there are no differences in tax rate applicable to capital
gains and dividends.

3. A firm has a given investment policy which does not change. The operational implication
of this assumption is that financing of new investment out of retained earnings will not
change the business risk complexion of the firm and therefore, no change in the required
rate of return.
4. There is a perfect certainty by every investor as to future investments and profits of the
firm. In other words, investors are able to forecast future prices and dividends with certainty.
This assumption is dropped by MM later.

MM Hypothesis: The Crux of the Argument

The crux of the MM position on the irrelevance of dividend is the arbitrage argument. Arbitrage
refers to entering simultaneously into two transactions, which balance each other. The two
transactions involve the payment of dividend on one side and raising external funds either
through the sale of new shares or to raise loans – to finance investment programmers. Suppose
a firm has some investment opportunity, it has two alternatives (1) it can retain its earnings to
finance the investment or (2) distribute the dividend to the shareholders and raise an equal
amount externally through sale of new shares. In case, the firm selects the second alternative,
arbitrage process is involved in that the payment of dividends is associated with raising of funds
through other means of financing. The effect of dividend payment on the shareholders wealth
will be exactly offset by the effect of raising additional shares.
When dividends are paid, the market price of the shares will increase. But the issue of additional
shares will cause a decline in the terminal value of the shares. What is gained by investors
through increase dividends will be offset by the reduction in terminal value of the shares. The
market price before and after payment of dividend would be same. The investors according to
MM, is indifferent between dividend and retention of earnings. Since the shareholders are
indifferent, the wealth would not be affected by current and future dividend decisions of the
firm. It would depend entirely upon the expected future earnings of the firm.

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