Page 308 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes 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

And (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
+
1
E
nP = [nD 1 +(n n )P 1 - + - nD ]
1
1
0 (1 + K )
e
E
+
nD 1 +(n n )P 1 - + - nD 1
1
1
=
1 + k e
(n + n )P 1 - + E
1
1
= …. (6)
(1 + k )
e
[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.
Solution: To prove that MM model holds good, we have to show that the value of the firm
remains the same whether dividends are paid or not.
1. The value of the firm, when dividends are paid:
Step 1: Price per share at the end of year I

1
P = (d 1 + P )
1
0 (1 + k )
e
1
100 = (3 + P )
1
1.12
P = 109
1

302 LOVELY PROFESSIONAL UNIVERSITY