Modigliani and Miller approach
Dividend Irrelevance Theory
[Financial Management Notes for NEP and CBCS Pattern]
Modigliani and Miller approach (M & M Hypothesis)
The residuals theory of dividends tends to imply that the dividends are irrelevant and the value of the firm is independent of its dividend policy. The irrelevance of dividend policy for a valuation of the firm has been most comprehensively presented by Modigliani and Miller. They have argued that the market price of a share is affected by the earnings of the firm and not influenced by the pattern of income distribution. What matters, on the other hand, are the investment decisions which determine the earnings of the firm and thus affect the value of the firm. They argue that subject to a number of assumptions, the way a firm splits its earnings between dividends and retained earnings has no effect on the value of the firm.
Like several financial theories, M&M
hypothesis is based on the argument of efficient capital markets. In addition,
there are two options:
(a) It retains earnings and finances
its new investment plans with such retained earnings;
(b) It distributes dividends, and
finances its new investment plans by issuing new shares.
Modigliani and Miller approach Assumptions
The intuitive background of the M&M
approach is extremely simple, and in fact, almost self-explanatory. It is based
on the following assumptions:
a) The capital markets are perfect and
the investors behave rationally.
b) All information is freely available to
all the investors.
c) There is no transaction cost.
d) Securities are divisible and can be
split into any fraction. No investor can affect the market price.
e) There are no taxes and no flotation
cost.
f) The firm has a defined investment
policy and the future profits are known with certainty. The implication is that
the investment decisions are unaffected by the dividend decision and the
operating cash flows are same no matter which dividend policy is adopted.
Their conclusion is that, the shareholders get
the same benefit from dividend as from capital gain through retained earnings.
So, the division of earnings into dividend and retained earnings does not
influence shareholders' perceptions. So whether dividend is declared or not,
and whether high or low payout ratio is follows, it makes no difference on the
value of the share. In order to satisfy their model, MM has started with the
following valuation model.
P0=
1* (D1+P1)/ (1+ke)
Where,
P0
= Present market price of the share
Ke
= Cost of equity share capital
D1
= Expected dividend at the end of year 1
P1
= Expected market price of the share at the end of year 1
With
the help of this valuation model we will create an arbitrage process, i.e.,
replacement of amount paid as dividend by the issue of fresh capital. The
arbitrage process involves two simultaneous actions. With reference to dividend
policy the two actions are:
a) Payment of dividend by the firm
b) Rising of fresh capital.
With
the help of arbitrage process, MM have shown that the dividend payment will not
have any effect on the value of the firm. Even if the firm pays dividends,
resulting in an increase in market value of the share, the effect on the value
of the firm will be neutralized by the decrease in terminal value of the share.
Modigliani and Miller approach Criticism
MM theory is criticized on the invalidity of
most of its assumptions. Some of the criticisms are presented below:
a) First,
perfect capital market is not a reality.
b) Second,
transaction and floatation costs do exist.
c) Third,
Dividend has a signaling effect. Dividend decision signals financial standing
of the business, earnings position of the business, and so on. All these are
taken as uncertainty reducers and that these influence share value. So, the
stand of MM is not tenable.
d) Fourth,
MM assumed that additional shares are issued at the prevailing market price. It
is not so. Fresh issues - whether rights or otherwise, are made at prices below
the ruling market price.
e) Fifth,
taxation of dividend income is not the same as that of capital gain. Dividend
income upto Rs. 10000 is fully exempt, whereas capital gain attracts a flat 20%
tax in the case of individual assesses. So, investor preferences between
dividend and capital gain differ.
f) Sixth,
investment decisions are not always rational. Some, sub-marginal projects may
be taken up by firms if internally generated funds are available in plenty.
This would deflate ROI sooner than later reducing share price.
g) Seventh,
investment decisions are tied up with financing decisions. Availability of
funds and external constrains might affect investment decisions and rationing
of capital, then becomes a relevant issue as it affects the availability of
funds.
Also Read: Dividend Decisions Important Questions for Upcoming Exams
Q. What is Dividend and Dividend Policy? What are various types of dividend and dividend policies? 2014SN, 2015, 2016, 2017
Q. What are the factors affecting dividend decision of a firm? 2014
Q. Explain the MM theory of dividend distribution. Mention its assumptions. What are the major criticisms to this theory of irrelevance? 2012, 2013, 2015, 2016, 2018, 2021
Q. Explain the Walter’s theory of dividend distribution. Mention its assumption. What are the shortcomings tothis theory? 2017, 2019, 2022
Q. What do you mean by ploughing backof profits? Mention the purpose of creating it. What are the factors thatinfluence the ploughing back of profit? 2012, 2013, 2014, 2019, 2021
Q. Write Short notes on:
Ø Stable Dividend policy 2012, 2017
Ø Optimal Payout Ratio 2013, 2017, 2022
Ø Dividend Payout Ratio 2014
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