Page 223 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes 2. Normal capitalization rate equal to capitalisation rate: In this case, the firm is doing
about as well as expected and the shareholder probably does not care about the level of
dividends. Intrinsic value will be 20 at all payout levels.
3. Normal capitalisation rate more than actual capitalization rate: In this situation, the
firm is not doing as well as expected. It is expected that the intrinsic value to rise if the firm
increased its dividend payout. Since the shareholders would like to have cash to invest at
higher return elsewhere. The intrinsic value at different payout ratios are worked out as
below:
.6 .6
30% Div. Payout = = = 12
12% – (10% × 70%) 5%
1 1
50% Div. Payout = = =14.3
12% - (10% 50% ) 7%

1.4 1.4
70% Div. Payout = = = 15.55
12% – (10% × 30%) 9%
2 2
100% Div. Payout = = = 16.67
12% – (10% ×0%) 12%
The intrinsic value increases from 12 to 16.67 when the payout ratio is raised from 30% to
100%.

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.

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