mm hypothesis of dividend irrelavence

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)

The term ‘dividend’ refers to that portion of company’s net earnings that is paid out to the equity shareholders.

DIVIDEND POLICY

BUT not for preference shareholders, since they are entitled to have a fixed rate of dividend.

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.

DIVIDEND POLICY

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.

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 point, a distribution of the firm’s earnings. 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.

Example: If the stock is purchased at 40 and sold for 60, the investor will realize a capital gain of 20.

FACTORS AFFECTING DIVIDEND DECISIONS

FACTORS AFFECTING DIVIDEND DECISIONSReduction 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 DIVIDENDSPerception 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 DIVIDENDSFlexibility 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 funds—both equity and debt—to 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.

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.

ASSUMPTIONS

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.


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.


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 firm’s 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

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.

P₀=

where,P0 = The prevailing market price of a shareKe = The cost of equity capitalD1 = the dividend to be paid at the end of the period oneP1 = The market price of a share at the end of period one with no external financing1

STEP 1

MM HYPOTHESIS PROOF

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= 2

STEP 2

MM HYPOTHESIS PROOF

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 P₁, eq. (1) can be written as:

3

P₀= 1

nP0=

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

STEP 3

MM HYPOTHESIS PROOF

If the firm were to finance all investment proposals, the total amount raised through new shares issued would be given in Eq. 4.

4

STEP 4

∆nP₁ = I - (E- nD₁) or ∆nP₁= I - E + nD₁ where

∆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, nD₁= Total dividends paid, and (E-nD₁) = 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

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

5

STEP 5

nP₀=

nP₀ =

nP₀ = 6

MM HYPOTHESIS PROOF

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.

STEP 6

• 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 EXAMPLE

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 IP₀=

100 =

P₁= Rs. 109

• Step 2: Amounts to be raised by the issue of new shares to finance investment requirement:

• nP₁ = I – (E – nD₁)• = 5,00,000 – (3,50,000 – 25,000 × 3)• = 2,25,000• Step 3: No. of shares to be raised


∆n = Nos.

• Step 4: Value of the firm

Value of the firm nP₀ = 25,00,000


nP₀ =

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


P₀=

100= P₁/1.12Or P₁= 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

• Step 4: Value of the firm


nP₀ =

Value of the firm nP = ₀ 25,00,000Thus the value of the firm in both the cases remains the same.

• 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 investors, broadly speaking, is of two types:

• tax on dividend income, and • Capital gains.

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 vice-versa. 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 of holdings periodically is inconvenient.

CRITICAL ANALYSIS

• 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

mm hypothesis of dividend irrelavence

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