Analysis of Financial Statements_5

DIVIDEND IRRELEVANCE : THE MILLER – MODIGLIANI (MM) HYPOTHESIS

According to Miller and Modigliani (MM), Hypothesis under a prefect market situation, the dividend policy of firm is irrelevant, as it does not affect the value of the firm. They argue that the value of the firm depends on the firm’s earnings that result from its investment policy.

A firm, operating in perfect capital market conditions, may face one of the following three situations regarding the payments of dividends:

The firm has sufficient cash to pay dividends.

The firm does not have sufficient cash to pat dividends, and therefore, it issue new shares to finance the payments of dividends.

The firm does not pay dividends, but a shareholder need cash.

In all the above three situation, when the firm pay dividends, shareholder get cash in their hands, but the firm assets reduce . What shareholder gain in the form of cash dividends, they lose in the form of their claims on the assets. Thus, there is a transfer of wealth from shareholder’s pocket to their another pocket. There is gain no loss. Since it is a fair transaction under perfect capital market condition, the value of the firm will remain unaffected.

MM ‘s hypothesis of irrelevance is based on the following assumptions:

Perfect capital markets.

No taxes.

Investment policy.

No risk.

ILLUSTRATION

Market price per share of XYZ Ltd., is Rs 100 each. The firm has net profit of Rs 10 lakhs. The firm thinking of declaring dividend of Rs 5 per share at the end of current fiscal year. The firm opportunity cost of capital is 10 % . What will be the price of the share at the end of the year if ….

(i) a dividend is not declared ;

(ii) a dividend is declared ?

SOLUTION :

The price of the share at the end of the current fiscal year is determined as follows :

DIV1 + P1

Po =

(1+k)

PO = Market price per/ share.

P1= Market price at end of the fiscal year.

(1+k) = cost of capital.

D1 = Dividend per share.

P1 = Po (1+k) – DIV1

The value of P1 when dividend is The value of P1 when dividend is

not paid paid

P1 = Rs 100(1.10) – 0 P1 = Rs 100 (1.10) – Rs 5

P1 = Rs 110 P1 = Rs 105

Rs 105 + Rs 5

=110

Whether dividend paid or not paid doesn’t make any difference to investors. Hence the policy is irrelevance.