Page 208 - DMGT409Basic Financial Management

Unit 13: Theory and Forms of Dividend

2. D/P ratio of 30%. Retention ratio is 70% Notes

15 (1 0.7− )
P =
−
×
0.11 0.7 0.10
= ` 112.50
3. D/P ratio 50%. Retention ratio = 50%
15 (1 0.5− )
P =
−
×
0.11 0.5 0.10
= ` 125
From the above it is clear that, when R>K, the price per share increases and the payout ratio
decreases, if R=K price per share remains same at all payout ratios. When R<K, the price per
share increases with the increases in the payout ratio.

13.1.3 Modigliani-Miller Model (Irrelevance Theory)

According to MM, the dividend policy of a firm is irrelevant, as it does not affect the wealth of

shareholders. The model which is based on certain assumptions, sidelined the importance of the

dividend policy and its effect thereof on the share price of the firm. According to the theory, the

value of a firm depends solely on its earnings power resulting from the investment policy and

not influenced by the manner in which its earnings are split between dividends and retained
earnings.
Explanation of MM’s Arguments

M-M’s irrelevance approach is based on arbitrage argument. Arbitrage is the process of entering
into such transactions simultaneously as exactly balance or completely offset each other. The
two transactions in the present case are payment of dividends and garnering funds to exploit

investment opportunities. Suppose, for example, a firm decides to invest in a project it has
alternatives:
1. Pay out dividends and raise an equal amount of funds from the market;

2. Retain its entire earnings to finance the investment programme. The arbitrage process is
involved where a firm decides to pay dividends and raise funds from outside.

When a firm pays its earnings as dividends, it will have to approach market for procuring

funds to meet a given investment programme. Acquisition of additional capital will dilute
the firms share capital which will result in drop in share values. Thus, what the stockholders

gain in cash dividends they lose in decreased share values. The market price before and after
payment of dividend would be identical and hence the stockholders would be indifferent
between dividend and retention of earnings. This suggests that dividend decision is irrelevant.
M-M’s argument of irrelevance of dividend remains unchanged whether external funds are
obtained by means of share capital or borrowings. This is for the fact that investors are indifferent
between debt and equity with respect to leverage and cost of debt is the same as the real cost of
equity.
Finally, even under conditions of uncertainty, divided decision will be of no relevance because of

operation of arbitrage. Market value of share of the two firms would be the same if they identical
with respect to business risk, prospective future earnings and investment policies. This is because
of rational behavior of investor who would prefer more wealth to less wealth. Difference in

respect of current and future dividend policies cannot influence share values of the two fi rms.

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