Mm approach of dividend policy

Dividend policy

1. Financial Management Seminar Presented By Rodixon & Sona

2. “ Modigilani - Miller Theory of Dividend Policy” Dividend Dividend Policy Valuation

3. 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

4. MM Theory of Dividend Policy

5. 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.

6. 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

7. Assumptions of the Model Perfect 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 .

8. Proof Step 1 The 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, P = 1 ( D 1 +P 1 ) ( 1 + k e ) Where P = Prevailing market price of a share, k e = Cost of equity capital D 1 = Dividend to be received at the end of period 1 and P 1 = Market price of a share at the end of period 1.

9. 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 (P ). Thus, nP = 1 (nD 1 +nP 1 ) ( 1+k e ) Step 3 If 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 P 1 then equation nP = 1 [(nD 1 +(n+∆n)P 1 -∆nP 1 )] (1+k e )

10. Step 4 If the firm were to finance all investment proposals, the total amount raised through new shares issued would be given in equation ∆nP 1 = I-(E-nD 1 ) ∆nP 1 = I-E+nD 1 ∆ 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 period nD 1 = total dividend paid out E-nD 1 = Retained earnings

11. Step 5 If we substitute Eq4 into Eq3 we derive nP = 1 [ nD 1 +(n+ ∆ n)P 1 -(I-E+nD 1 ) ] (1+k e ) Solving it nP =nD 1 +(n+ ∆ n)P 1 -I+E-nD 1 (1+K e ) There is positive and negative nD 1. so nD 1 cancels. We then have nP =(n+ ∆ n)P 1 -I+E (1+K e ) Step 6 Conclusion Since 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.

12. 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

13. Thank You……………..!