MODIGLIANI AND MILLER

APPROACH
( MM Approach)
Modigliani and Miller Approach (MM model)

They maintain that dividend policy has no effect
on the market price of the shares and the value of
the firm is determined by the earning capacity of
the firm or the investment policy .
As observed by M.M ,Under condition of perfect
capital markets , rational investors , absence of
tax discrimination between dividend income and
capital appreciation , given the firms investment
policy , its dividend policy may have no influence
on market price of the share.
It is argued that dividend policy has no effect on the
market price of the shares and the value of the form is
determined by the earning capacity of the firm or the
investment policy
Argument of MM approach?
ASSUMPTIONS
The capital markets are perfect and the investors
behave rationally.
All information is freely available to all the investors.
There is no transaction cost and time lag
Securities are divisible and can be split into any
fraction. No investor can affect the market price.
There are no taxes and no flotation cost.
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.

Mathematical Expression


Where, po= Present market price of the share.
D1= Expected dividend at the end of year 1.
p1=Expected market price of the share at the
end of year 1.
ke = cost of equity capital.

EXAMPLE
A firm has 1,00,000 shares outstanding and is planning to declare a dividend of Rs. 5
at the end of the current financial year. The present market price of the share is Rs.
100. The cost of equity capital, ke, may be taken at 10%. The expected market price
at the end of the year 1 may be found under two options: (i) if dividend of Rs. 5 is
paid, and (ii) if the dividend is not paid.
When Dividend of Rs.5 is paid (the value of D1 is 5) :
P0 = (D1 + P1)/ (1+ ke)
P0 (1+ ke) = D1 + P1
P1 = P0 (1+ ke) D1
= 100(1.10) 5
= 105
So, the market price is expected to be Rs.105, if the firm pays
dividend of Rs.5

When, Dividend of Rs.5 is not paid (the value of D1 is 0):
P0 = (D1 + P1)/ (1+ ke)
P0 (1+ ke) = D1 + P1
P1 = P0(1+ ke) D1
= 100(1.1)
= 110
So, the market price of the share is expected to be Rs.110, if
the firm does not pay any dividend.


nP0 = [(n + m)P1 I +E] / (1+ ke)
Formula to calculate the Value of the firm
Where, nP0 = value of the firm
n = number of equity shares outstanding
m = number of equity shares at price P1
P1= Expected market price of the share at the end of year 1
I = total investment to be made at year 1
E = total earnings of the firm

The same example can be extended further to analyze the effect of arbitrage
employed by the firm.
The firm has total profits of Rs.1000000 during the year 1 and is planning to make
an investment of Rs.2000000 at the end of the year 1. The arbitrage process and
value of the firm may be explained as follows:
If dividend of Rs.5 is paid by the firm at the end of year 1: (Rs.)
Total Earnings 10,00,000
(-)Dividends Paid (100000 * Rs.5) 5,00,000

Retained Earnings 5,00,000

Total funds required for investment 20,00,000
Therefore, fresh capital to be issued 15,00,000
Market price at the end of year 1 105
Number of shares to be issued (Rs.15,00,000/105) 14,285.71
Total number of shares (100000+14285.71) 1,14,285.71

Applying the formula, the value of the firm, nP0 is
nP0 = [(n + m)P1 I +E] / (1+ ke)
= [(114285.71)105 20,00,000 + 10,00,000] / (1.10)
= Rs.1,00,00,000

If dividend of Rs.5 is not paid by the firm at the end of the year 1: (Rs.)
Total earnings 10,00,000
(-)Dividends Paid -
Retained Earnings 10,00,000
Total funds required for investment 20,00,000
Therefore, fresh capital to be issued 10,00,000
Market price at the end of year 1 110
Number of share to be issued (1000000/110) 9090.9
Total number of shares (100000+9090.0) 1,09,090.9

Applying the formula, the value of the firm, nP0 is
nP0 = [(n + m) P1 I +E] / (1+ ke)
= [(109090.9)110 20,00,000 + 10,00,000]
= Rs.1,00,00,000
So, the value of the firm remains same at Rs.10000000 if the dividend is paid or not.
With the help of above process, it can be showed that dividend policy is irrelevant for
the valuation of the firm. Dividend payment does not affect the value of the firm.
It should be noted that, the formula used above, gives the current market value of the
firm. The MM model shows that if dividend is paid or not at the end of current year, the
present market value of the firm remains same at Rs.1,00,00,000. The same example
can be applied to find out the expected market value of the firm at the end of current
year as follows:
If dividend of Rs.5 is paid
Total number of shares 1,14,285.71
Market price Rs.105
Total market value (114285.71*105) Rs.1,20,00,000
If dividend of Rs.5 is not paid
Total number of shares 109090.90
Market price Rs.110
Total market value (109090.90*110) Rs.1,20,00,000

Thus, the expected market value remains same at Rs.1,20,00,000, whether the firm pays
dividend of Rs.5 or not. The MM Model shows therefore, that the current market value
or the expected market value of the firm, both are unaffected by the dividend decision
of the firm.
CRITICAL
APPRAISAL