What are the assumptions of MM approach?

Answer 1

The MM approach to irrelevance of dividend is based on the following assumptions:

• · The capital markets are perfect and the investors behave rationally.
• · All information is freely available to all the investors.
• · There is no transaction cost.
• · Securities are divisible and can be split into any fraction. No investor can affect the market price.
• · There are no taxes and no flotation cost.
• · The firm has a defined investment policy and the future profits are known with certainty. The implication is that the investment decisions are unaffected by the dividend decision and the operating cash flows are same no matter which dividend policy is adopted.

The model

Under the assumptions stated above, MM argue that neither the firm paying dividends nor the shareholders receiving the dividends will be adversely affected by firms paying either too little or too much dividends. They have used the arbitrage process to show that the division of profits between dividends and retained earnings is irrelevant from the point of view of the shareholders. They have shown that given the investment opportunities, a firm will finance these either by ploughing back profits of if pays dividends, then will raise an equal amount of new share capital externally by selling new shares. The amount of dividends paid to existing shareholders will be replaced by new share capital raised externally.

In order to satisfy their model, MM has started with the following valuation model.

P0= 1* (D1+P1)/ (1+ke)

Where,

P0 = Present market price of the share

Ke = Cost of equity share capital

D1 = Expected dividend at the end of year 1

P1 = Expected market price of the share at the end of year 1

With the help of this valuation model we will create a arbitrage process, i.e., replacement of amount paid as dividend by the issue of fresh capital. The arbitrage process involves two simultaneous actions. With reference to dividend policy the two actions are:

• · Payment of dividend by the firm
• · Rising of fresh capital.

With the help of arbitrage process, MM have shown that the dividend payment will not have any effect on the value of the firm. Even if the firm pays dividends, resulting in a increase in market value of the share, the effect on the value of the firm will be neutralised by the decrease in terminal value of the share.