Modigliani-Miller Dividend Irrelevance Theory: An Overview, Lecture notes of Business Accounting

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DIVIDEND POLICY

DIVIDEND THEORIES

MODIGLIANI AND MILLER’S

APPROACH

• According to MM, under a perfect market condition, the dividend policy of the company is irrelevant and it does not affect the value of the firm.
• “Under conditions of perfect market, rational investors, absence of tax discrimination its dividend policy may have no influence on the market price of shares”.
• MM approach is based on the following important assumptions:
• 1. Perfect capital market.
• 2. Investors are rational.
• 3. There are no tax.
• 4. The firm has fixed investment policy.
• 5. No risk or uncertainty.

MODIGLIANI AND MILLER’S

APPROACH

• MM approach can be proved with the help of the following formula:=
• Where,
• Po = market price of the share at the beginning of period
• Ke = Cost of equity capital.
• D1 = Dividend to be received at the end of period one.
• P1 = Market price of the share at the end of period one.

RELEVANCE OF DIVIDEND:

WALTER’S MODEL

• According to this concept, dividend policy is considered to affect the value of the firm.
• Prof. James E. Walter argues that the dividend policy almost always affects the value of the firm. Walter model is based in the relationship between the following important factors:
• Rate of return I
• Cost of capital (k)
• According to the Walter’s model, if r > k, the firm is able to earn more than what the shareholders could by reinvesting, if the earnings are paid to them.
• The implication of r > k is that the shareholders can earn a higher return by investing elsewhere.
• If the firm has r = k, it is a matter of indifferent whether earnings are retained or distributed.

ASSUMPTIONS

• Walters model is based on the following important assumptions:
• The firm uses only internal finance. (retained earning)
• The firm does not use debt or equity finance.
• The firm has constant return and cost of capital.
• The firm has 100 recent payout.
• The firm has constant EPS and dividend.
• The firm has a very long life.

CRITICISM OF WALTER’S MODEL

• Walter model assumes that there is no extracted finance used by the firm. It is not practically applicable.
• There is no possibility of constant return. Return may increase or decrease, depending upon the business situation. Hence, it is applicable.
• According to Walter model, it is based on constant cost of capital. But it is not applicable in the real life of the business.

GORDON’S MODEL

• Myron Gorden suggest one of the popular model which assume that dividend policy of a firm affects its value, and it is based on the following important assumptions:
• The firm is an all equity firm.
• The firm has no external finance.
• Cost of capital and return are constant.
• The firm has perpectual life.
• There are no taxes.
• Constant relation ratio (g=br). . Cost of capital is greater than growth rate (Ke>br).

CRITICISM OF GORDON’S MODEL

• Gordon model assumes that there is no debt and equity finance used by the firm. It is not applicable to present day business.
• Ke and r cannot be constant in the real practice.
• According to Gordon’s model, there are no tax paid by the firm. It is not practically applicable.

GORDAN’S REVISED MODEL

• Gordon revised his basic model to consider risk &uncertainty.
• He suggested that even r=k, dividend policy affects the value of shares on account of uncertainty of future.
• Investors are rational &they want to avoid risk
• They prefer near dividend than future dividend
• “bird in the hand is better than in bush”