Page 224 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 9: Dividend Decisions

MM Hypothesis: The Crux of the Argument Notes

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.

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 + P ) ……(1)
1
1
0 (1 + K )
e
where,
P = The prevailing market price of a share
0

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