MM HYPOTHESIS OF

DIVIDEND IRRELEVENCE
BY:
IVANI KATAL(27-MBA-15)
MANHAR MALHOTRA(29-MBA-15)
MITALI SHARMA(31-MBA-15)
NAVJOT SINGH ARORA(33-MBA-15)
NIKHIL KUMAR(35-MBA-15)
NISHANT SUMAN(37-MBA-15)

DIVIDEND POLICY
The term dividend refers to that portion of
companys net earnings that is paid out to the equity
shareholders.
BUT not for preference shareholders, since
they are entitled to have a fixed rate of
dividend.

DIVIDEND POLICY
Dividend policy of a firm decides the portion of
earnings is to be paid as dividends to ordinary
shareholders and the portion that is ploughed back
in the firm for investment purpose.
When a company uses a part of its net earnings for
dividend payments then, the remaining earnings are
retained.
Thus, there is an inverse relationship between retained
earnings and payment of cash dividend-the larger the
cash dividends and lesser the retention, smaller the cash
dividends and larger retentions.

FACTORS AFFECTING DIVIDEND

DECISIONS
Capital gains: The investor expects an
increase in the market value of the common
shares over a period of time.
Dividends: The investor expects at some
Example: If the stock is purchased at 40 and sold for
point, a distribution of the firms earnings.
60, the investor will realize a capital gain of 20.
From mature and stable organizations, most
investors expect regular dividends to be declared
and paid on the common shares. This expectation
takes priority over the desire to retain earnings to
finance expansion and growth.

FACTORS AFFECTING DIVIDEND

DECISIONS
Reduction of uncertainty: The promise of
future capital gains or a future distribution of
earnings, involves more uncertainty than a
distribution of current earnings.
Indication of strength: The declaration and
payment of cash dividend carries some sort of
confidence that the firm is reasonably strong and
healthy.
Need for current income: Many shareholders
require a regular flow of income through their
investments, for their day-to-day expenses.

IMPORTANCE OF STABILITY OF
DIVIDENDS

Perception of stability: When a firm pays

regular dividend it is considered as a sign of
continued normal operations. On the other hand, a
reduction in dividend payment will be treated as a
sign of impending trouble for the company.
Preference
of
investors:
The
common
shareholders of mature firms generally prefer
to receive steady dividends.
Dividend
decisions
as
a
routine:
By
establishing a stable dividend policy, the board
of directors avoids a lengthy discussion on dividend
levels.

IMPORTANCE OF STABILITY OF
DIVIDENDS

Flexibility of the extra dividend: With a

steady dividend policy, the firm can flexibly
handle period temporarily high earnings, by giving a
slightly large distribution of earnings without raising
the expectation of investors.
Desire
for
current
income
by
the
shareholders: Desire for current income by
some investors, such as, retired persons and
widows. Such group of investors may be willing to
pay a higher share price to avoid the inconvenience
of erratic dividend payment, which disrupts their
budgeting. They would place positive utility on stable
dividends.

IRRELEVENCE OF DIVIDENDS
Firms that pay more dividends offer less price
appreciation but must provide the same total return to
stockholders, given their risk characteristics and the
cash flows from their investment decisions.
Thus, there are no taxes, or if dividends and capital
gains are taxed at the same rate, investors should be
indifferent to receiving their returns in dividends or
price appreciation.
When a firm has sufficient investment opportunities, it
will retain the earnings to finance them.
But if acceptable investment opportunities are
inadequate, the implication is that the earnings would
be distributed to the shareholders.

IRRELEVENCE OF DIVIDENDS
The test of adequate acceptable investment
opportunities is the relationship between the return on
the investments (r) and the cost of capital (k). As long
as r exceeds k, a firm has acceptable investment
opportunities.
If the retained earnings fall short of the total funds
required it will raise external fundsboth equity and
debtto make up the shortfall.
If, however, the retained earnings exceed the
requirements of funds to finance acceptable
investment opportunities, the excess earnings would
be distributed to the shareholders in the form of cash
dividends.

MODIGLIANI AND MILLER (MM)

HYPOTHESIS
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..

ASSUMPTIONS
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.
There are no taxes. Alternatively, there are no
differences in tax rate applicable to capital gains and
dividends.

ASSUMPTIONS
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.
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.

CRUX OF THE ARGUMENT

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.

CRUX OF THE ARGUMENT

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.

CRUX OF THE ARGUMENT

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.
With dividends being irrelevant, a firms 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.

MM HYPOTHESIS PROOF

STEP 1

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.

P=

where,
P0 = The prevailing market price of a
share
Ke = The cost of equity capital
D1 = the dividend to be paid at the end of
the period one
P1 = The market price of a share at the
end of period one with no external
financing

MM HYPOTHESIS PROOF

STEP 2

Assuming 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).

nP0=

MM HYPOTHESIS PROOF

STEP 3

If the firm's internal sources of financing its investment

opportunities fall short of the funds required, and n is the
number of new shares issued at the end of year I at price of P,
eq. (1) can be written as:

P=
nP0=

1
3

where n= Number of shares outstanding at the beginning

of the period, and
n= Change in the number of shares outstanding during
the period/Additional shares issued

MM HYPOTHESIS PROOF

STEP 4

If the firm were to finance all investment proposals, the total

amount raised through new shares issued would be given in Eq. 4.
nP = I - (EnD)
or

nP= I - E +

nD
where
nP= 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 period,
nD= Total dividends paid, and
(E-nD) = Retained earnings
According to Equation 4, whatever investment needs are not financed by
retained earnings, must be financed through the sale of additional equity
shares.

MM HYPOTHESIS PROOF

STEP 5

If we substitute Eq.4 into Eq.3 we derive Eq.5.

nP=

nP =

nP =

MM HYPOTHESIS PROOF

STEP 6

Conclusion Since dividends (D) are not found in Eq. 6, Modigliani

and Miller conclude that dividends do not count and that dividend
policy has no effect on the share price.

MM HYPOTHESIS EXAMPLE

Example: The capitalization rate of A Ltd.

is 12%. The company has outstanding
shares to the extent of 25,000 shares
selling @ Rs. 100 each. Assume, the net
income anticipated for the current financial
year of Rs. 3,50,000. A Ltd. plans to
declare a dividend of Rs.3 per share. The
company has investment plans for new
project of Rs. 5,00,000. Show that under
the MM Model, the dividend payment does
not affect the value of the firm.

MM HYPOTHESIS SOLUTION
To prove that MM model holds good, we have to show that
the value of the firm remains the same whether dividends
are paid or not.
1. The value of the firm, when dividends are
paid:
Step 1: Price per share at the end of year I

P=

100 =
P= Rs. 109

MM HYPOTHESIS SOLUTION

Step 2: Amounts to be raised by the issue of

new shares to finance investment requirement:

nP = I (E nD)

= 5,00,000 (3,50,000 25,000 3)

= 2,25,000

Step 3: No. of shares to be raised

n =

Nos.

MM HYPOTHESIS SOLUTION

Step 4: Value of the firm

nP =

Value of the firm nP = 25,00,000

MM HYPOTHESIS SOLUTION
2. The value of the firm, when dividends are
NOT paid:
Step 1: Price per share at the end of year I

P=

100= P/1.12
Or P= Rs. 112
Step 2: Amount to be raised from the issue of shares
5,00,000 3,50,000 = 1,50,000
Step 3: No. of shares to be raised = 1,50,000/1.12

MM HYPOTHESIS SOLUTION

Step 4: Value of the firm

nP =

alue of the firm nP = 25,00,000

hus the value of the firm in both the cases remains the same.

CRITICAL ANALYSIS

Modigliani and Miller argue that the dividend

decision of the firm is irrelevant in the sense
that the value of the firm is independent of it.

The crux of their argument is that the

investors are indifferent between dividend
and retention of earnings.

This is mainly because of the balancing

nature
of
internal
financing
(retained
earnings) and external financing (raising of
funds
externally)
consequent
upon
distribution of earnings to finance investment
programs.

CRITICAL ANALYSIS

The validity of the MM Approach is open to

question on two counts:

Imperfection of capital market, and

Resolution of uncertainty.

CRITICAL ANALYSIS

Market Imperfection

Modigliani and Miller assume that capital

markets are perfect.

This implies that there are no taxes; flotation

costs do not exist and there is absence of
transaction costs. These assumptions are
untenable in actual situations.

CRITICAL ANALYSIS

Tax Effect

An assumption of the MM hypothesis is that there

are no taxes.

It implies that retention of earnings (internal

financing) and payment of dividends (external
financing) are from the viewpoint of tax treatment, on
an equal footing.

The investors would find both forms of financing

equally desirable.

The tax liability of the

speaking, is of two types:

tax on dividend income, and

Capital gains.

investors,

broadly

CRITICAL ANALYSIS

Tax on dividend income is payable by the

investors when the firm pays dividends, the
capital gains tax is related to retention of
earnings.

From an operational viewpoint, capital gains tax

is

(1) Lower than the tax on dividend income and

(2) it becomes payable only when shares are

actually sold, that is, it is a deferred tax till
the actual sale of the shares.

CRITICAL ANALYSIS

Flotation Costs

The term flotation cost' refers to the cost involved in raising

capital from the market, for instance, underwriting
commission, brokerage and other expenses.

The presence of flotation costs affects the balancing nature of

internal (retained earnings) and external (dividend payments)
financing.

The MM position, it may be recalled, argues that given the

investment decision of the firm, external funds would have
to be raised, equal to the amount of dividend, through the
sale of new shares to finance the investment programme.

The two methods of financing are not perfect substitutes

because of flotation costs. The introduction of such costs
implies that the net proceeds from the sale of new shares would be
less than the face value of the shares, depending upon their size.

The smaller the size of the issue, the greater is the

percentage flotation cost.

CRITICAL ANALYSIS

Transaction and Inconvenience Costs

Yet another assumption which is open to Transaction question is

that there are no transaction costs in the capital market.

Transaction costs refer to costs associated with the sale of

securities by the shareholder-investors.

The no-transaction costs postulate implies that if dividends

are not paid (or earnings are in selling retained), the investors
desirous of current income to meet consumption needs can sell
a part of their holdings without incurring any cost, like
brokerage and so on.

This is obviously an unrealistic assumption. Since the sale of

securities involves cost, to get Current income equivalent to the
dividend, if paid, the investors would have to sell securities in
excess of the income that they will receive.

CRITICAL ANALYSIS

Institutional Restrictions

The dividend alternative is also supported by

legal restrictions as to the type of ordinary
shares in which certain investors can invest.

For instance, the life insurance companies are

permitted in terms of section 27-A (1) of the
Insurance Act, 1938, to invest in only such
equity shares on which a dividend of not less
than 4 per cent including bonus has been
paid for 7 years or for atleast 7 out of 8 or 9
years imrnediately preceding.

To be eligible for institutional investment,

legal
impediments,
therefore,
favour
dividends to retention of earnings.

CRITICAL ANALYSIS

Resolution
of
Uncertainty
Apart
from
the
market
imperfection, the validity of the MM hypothesis insofar as it
argues that dividends are irrelevant, is questionable under
conditions of uncertainty.

MM hold, it would be recalled, that dividend policy is as irrelevant

under conditions of uncertainty as it is when perfect certainty is
assumed.

The MM hypothesis is, however, not tenable as investor

cannot be indifferent between dividend and retained
earnings under conditions of uncertainty. It can be illustrated
with reference to four aspects:

(i) Near vs distant dividend,

(ii) Information content of dividends;

(iii) Preference for current income; and sale of stock at

uncertain price, under pricing.

CRITICAL ANALYSIS

Near Vs Distant Dividend

One aspect of the uncertainty situation is the

payment of dividends now or at a later date.

If the earnings are used to pay dividends to the

investors, they get immediate or 'near
dividend.

If, however, the net earnings are retained, the

shareholders would be entitled to receive a return
after some time in the form of an increase in the
price of shares (capital gains) or bonus shares and
so on. The dividends may, then, be referred to as
'distant' or 'futures dividends.

CRITICAL ANALYSIS

Informational content of dividends It is the information

provided by dividends of a firm with respect to future earnings
which causes owners to bid up or down the price of shares.

Another aspect of uncertainty related to the first (i.e.

resolution of uncertainty) is the informational Content of
Dividends. According to the latter argument, as the name
suggests, the dividend contains some information vital to the
investors. The payment of dividend conveys to the
shareholders information relating to the profitability of the
firm. If, for instance, a firm has been following a stable
dividend policy in the sense of, say, rs4 per share dividend, an
increase in the amount to, say rs5 per share will signify that
the firm expects its profitability to improve in future or viceversa. The dividend policy is likely to cause a change in the
market price of the shares.

CRITICAL ANALYSIS

Preference for Current Income The third aspect

of the uncertainty question relating to dividends is
based on the desire of investors for current income
to meet consumption requirements. The MM
hypothesis of irrelevance of dividends implies that
in case dividends are not paid, investors who prefer
current income can sell a part of their holdings in
the firm for the purpose. But under uncertainty
conditions, the two alternatives are not on the
same tooting because

(1) The prices of shares fluctuate so that

selling price is uncertain, and

(2) Selling a small fraction

periodically is inconvenient.

of

holdings

Under pricing Finally, the MM hypothesis would also not be valid when
conditions are assumed to be uncertain because of the prices at which firms
can sell shares to raise funds to finance investment programmes
consequent upon the distribution of earnings to the shareholders.

The irrelevance argument would be valid provided the firm is able to sell
shares to replace dividends at the current price. Since the shares would
have to be offered to new investors, the firm can sell the shares
only at a price below the prevailing price. The underpricing or sale
of shares at prices lower than the prices lower than the current market
price implies that the firm will have to sell more shares to replace the
dividend.

The considerations that support the preposition that investors

have a systematic preference for current dividend relative to
retained earnings are

desire for current income,

Resolution of uncertainty and allied aspect of informational

content of dividends.

Transaction and inconvenience casts, and

Under pricing of new shares.

THANK YOU