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MM Approach

I. Modigliani and Miller (MM) Approach: Dividend Irrelevance Revisited

Modigliani and Miller (MM) strongly support the dividend irrelevance theory. They argue that under ideal conditions, dividend policy has no impact on a firm's market value.

MM's Central Argument:

A firm's value is determined by its earning capacity and investment policy, not by how it chooses to split earnings between dividends and retentions.

Perfect Market Assumptions:

MM's theory relies on these key assumptions:

  1. Perfect Capital Markets:
    • No transaction costs
    • No Taxes
    • Complete information, same to all
    • Investors can borrow and lend freely at the same rate.
  2. Rational Investors: Investors act logically and seek to maximize wealth.
  3. Rigid Investment Policy: The company's investment decisions are fixed and independent of dividend policy.
  4. No Tax Distortions: There are no tax differences between dividend income and capital gains.
  5. No investor large enough to affect market price.

MM's Reasoning:

MM argue that any increase in firm value from paying dividends is exactly offset by a corresponding decline in share price due to external financing. Consider the following: To be more specific, the market price of share in beginning of period is equal to present value of dividends paid at end of period plus the market price of shares at end of period plus the market price of shares at end of the period.

MM's Fundamental Equation:

P0 = D1 + P1/ (1 + Ke)

Where:

*PO = Market price per share at beginning of period. *D1 = Dividend to be received at end of period. *P1 = Market price per share at end of period. *Ke = Cost of equity capital.

In case of investments

Value of new shares can be calculated:

m = number of shares to be issued. I = Investment required. E = Total earnings of the firm during the period. P1 = Market price per share at the end of the period. Ke = Cost of equity capital. n = number of shares outstanding at the beginning of the period. D1 = Dividend to be paid at the end of the period. nPO = Value of the firm.

II. Limitations of the MM Approach

The MM hypothesis is criticized because its assumptions are unrealistic:

  1. Imperfect Capital Markets: Transaction costs, information asymmetry, and borrowing restrictions exist in the real world.
  2. Tax Distortions: Dividends and capital gains are often taxed at different rates.
  3. Flotation Costs: Issuing new securities incurs floatation costs.
  4. Fixed Investment Policy: Companies often adjust investment plans based on available funds.

III. Dividends and Uncertainty: The Bird-in-the-Hand Argument

Gordon concludes that uncertainty increases with futurity; that is the further one looks into the future the more uncertain dividends become. Accordingly, when dividend policy is considered in the context of uncertainty, the appropriate discount rate, k cannot be assumed to be constant, in fact. it increases with uncertainty; investors prefer to avoid uncertainty and would be willing to pay higher price for the share that pays the greater current dividend, all other things held constant.

This view is based on the assumption that under conditions of uncertainty, investors tend to discount distant dividends (capital gains) at a higher rate than they discount near dividends.

Example to illustrate the point.

The HCL Limited currently has 2 crore outstanding shares selling at a market price of Rs. 100 per share. The firm has no borrowing. It has internal funds available to make a capital expenditure (capex) of Rs. 30 crore. The capex is expected to yield a positive net present value of Rs. 20 crore. The firm also wants to pay a dividend per share of Rs. 15. Given the firm's capex plan and its policy of zero borrowing, the firm will have to issue new shares to finance payment of dividends to its shareholders. How will the firm's value be affected (i) if it does not pay any dividend; (ii) if it pays dividend per share Rs. 15Rs.

The firm's current value is: 2 x 100 = Rs. 200 crore. After the capex, the value will Increase to: 200 + 20 = Rs. 220 crore. If the firm does not pay dividends, me value per share will be: 220/2 = Rs. 110.

If the firm pays a dividend of Rs. 15 per share, it will entirely utilise its internal funds (15x2 = Rs. 30 crore), and it will have to raise Rs. 30 crore by issuing new shares lo undertake capex. The value of a share after paying dividend will be: 110 - 15 = X 95. Thus, the existing shareholders get cash of f 15 per share in the form of dividends, but incur a capital loss of Rs. 15 in the form of reduced share value. They neither gain nor lose. The firm will have to issue: 30 crore/95 = 31,57,895 (about 31.6 lakh) share to raise Rs. 30 crore. The firm now has 2.316 crore shares at Rs. 95 each share. Thus, dfl value of the firm remains as: 2.316 x 95 = Rs. 220 crore.

The above illustration demonstrates that the total returns to shareholders is the same, regardless of the dividend payout.

Conclusion: A Complex and Context-Dependent Decision

The ideal dividend policy is complex and depends on a company's circumstances, investor base, and market environment.

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