3. Dividend
Theories
Relevance Theories
(i.e. which consider
dividend decision to be
relevant as it affects the
value of the firm)
Walter’s
Model
Gordon’s
Model
Irrelevance Theories
(i.e. which consider dividend
decision to be irrelevant as it
does not affects the value of
the firm)
Modigliani and
Miller’s Model
Traditional
Approach
4. 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
6. 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.
7. Value of Firm (i.e. Wealth of Shareholders)
Firm’s Earnings
Firm’s Investment Policy and not on dividend policy
8. 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
9. 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.
10. 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,
P0= 1 ( D1+P1 )
(1 + ke)
Where P0= Prevailing market price of a share,
ke= Cost of equity capital
D1= Dividend to be received at the end of period 1 and
P1 = Market price of a share at the end of period 1.
11. 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 (P0). Thus,
nP0= 1 (nD1+nP1)
(1+ke)
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 P1 then
equation
nP0= 1 [(nD1+(n+∆n)P1-∆nP1)]
(1+ke)
12. Step 4
If the firm were to finance all investment proposals, the total amount
raised through new shares issued would be given in equation
∆nP1= I-(E-nD1)
∆nP1= I-E+nD1
∆ 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 dividend paid out
E-nD1= Retained earnings
13. Step 5
If we substitute Eq4 into Eq3 we derive
nP0= 1 [nD1+(n+∆n)P1-(I-E+nD1)]
(1+ke)
Solving it
nP0=nD1+(n+∆n)P1-I+E-nD1
(1+Ke)
There is positive and negative nD1. so nD1 cancels. We then have
nP0=(n+ ∆ n)P1-I+E
(1+Ke)
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.
14. 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