Financial Management Seminar

Presented ByRodixon &

Sona

“Modigilani- Miller Theory of Dividend Policy” Dividend

Dividend Policy

Valuation

Dividend Theories

Relevance Theories(i.e. which consider dividend decision to

be relevant as it affects the value of

the firm)

Walter’s Model

Gordon’s Model

Irrelevance Theories(i.e. which consider

dividend decision to be irrelevant as it does

not affects the value of the firm)

Modigliani and Miller’s

ModelTraditional Approach

According to this concept, investors do not pay any importance to the dividend history of a company and thus, dividends are irrelevant in calculating the valuation of a company. This theory is in direct contrast to the ‘Dividend Relevance’ theory which deems dividends to be important in the valuation of a company.

Irrelevance Theory

MM Theory

of Dividend Policy

Modigliani – Miller theory was proposed by Franco Modigliani and Merton Miller in 1961. They were the pioneers in suggesting that dividends and capital gains are equivalent when an investor considers returns on investment.

The only thing that impacts the valuation of a company is its earnings, which is a direct result of the company’s investment policy and the future prospects.

Value of Firm (i.e. Wealth of Shareholders)

Firm’s Earnings

Firm’s Investment Policy and not on dividend policy

If a company retains earnings instead of giving it out as dividends, the shareholder enjoy capital appreciation equal to the amount of earnings retained.

If it distributes earnings by the way of dividends instead of retaining it, shareholder enjoys dividends equal in value to the amount by which his capital would have appreciated had the company chosen to retain its earning.

Hence, the division of earnings between dividends and retained earnings is IRRELEVANT from the point of view of shareholders

Assumptions of the ModelPerfect Capital Markets: This theory believes in the existence of ‘perfect capital markets’. It assumes that all the investors are rational, they have access to free information, there are no floatation or transaction costs and no large investor to influence the market price of the share.No Taxes: There is no existence of taxes.Fixed Investment Policy: The company does not change its existing investment policy. This means that new investments that are financed through retained earnings do not change the risk and the rate of required return of the firm.No Risk of Uncertainty: All the investors are certain about the future market prices and the dividends.

ProofStep 1The market price of a share in the beginning of the period is equal to the present value of dividends paid at the end of the period plus the market price of shares at the end of the period. Symbolically,

P0= 1 ( D1+P1 ) (1 + ke) Where P0= Prevailing market price of a share,

ke= Cost of equity capital D1= Dividend to be received at the end of period 1 and P1 = Market price of a share at the end of period 1.

Step 2Assuming no external financing, the total capitalized value of the firm would be simply the number of shares (n) times the price of each share (P0). Thus,

nP0= 1 (nD1+nP1)(1+ke)

Step 3If the firm’s internal source of financing its investment opportunities fall short of the funds required, and n is the number of new shares issued at the end of the year 1 at price of P1 then equation

nP0= 1 [(nD1+(n+∆n)P1-∆nP1)] (1+ke)

Step 4If the firm were to finance all investment proposals, the total amount raised through new shares issued would be given in equation

∆nP1= I-(E-nD1)∆nP1= I-E+nD1

∆ nP1= Amount obtained from the sale of new shares of finance capital budget, I= Total amount / Requirement of capital budget E= Earnings of the firm during the periodnD1= total dividend paid outE-nD1= Retained earnings

Step 5If we substitute Eq4 into Eq3 we derivenP0= 1 [nD1+(n+∆n)P1-(I-E+nD1)] (1+ke)Solving itnP0=nD1+(n+∆n)P1-I+E-nD1

(1+Ke)There is positive and negative nD1. so nD1 cancels. We then havenP0=(n+ ∆ n)P1-I+E (1+Ke)Step 6 ConclusionSince dividends are not in the final equation, MM concludes that dividends do not count and that dividend policy has no effect on the share price.

Criticisms No perfect Capital Market Existence of Transaction Cost Existence of Floatation Cost Lack of Relevant Information Differential rates of Taxes No fixed investment Policy Investor’s desire to obtain current income

Thank You……………..!