Page 307 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 14: Management of Surplus & Dividend Policy

Notes

Notes There would be no difference as per MM, if external funds are raised in the form of
debt instead of equity. This is because of their indifference between debt and equity with
respect of leverage. The cost of capital is independent of leverage and the real cost of debt
is the same as the real cost of equity.
The arbitrage process also implies that the total market value plus current dividends of two
firms, which are alike in all respects except Dividend Payout Ratio, will be identical. The
individual shareholder can retain and invest his own earnings and do this, as well as the firm.
With dividends being irrelevant, a firm’s cost of capital would be independent of its Dividend
Payout Ratio.
Finally, the arbitrage process will ensure that under conditions of uncertainty also the dividend
policy is irrelevant.
When two firms are similar in respect of business risk, the prospective future earnings and
investment policies, the market price of their shares must be the same. This MM considers, due
to the rational behaviour of the investors who prefer more wealth to less wealth. Differences in
current and future dividend policies cannot affect the market value of the two firms, as the
present value of prospective dividends plus terminal value are the same.

MM Hypothesis Proof

MM provides the proof in support of their argument in the following way:
In the first step, the market value of a share in the beginning of the period is equal to the present
value of dividend paid at the end of the period plus the market price of the share at the end of the
period. Symbolically:

1
P = (D 1 + P ) ……(1)
1
0 (1 + K )
e
where,
P = The prevailing market price of a share
0
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 financing
1
the total value of the firm will be as follows:
1
nP = (nD 1 + nP ) ...(2)
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 1 + (n n )P 1 - n P ] …. (3)
1
1
1
0 (1 + K )
e
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