Question 4 (a)
MM approach to the irrelevance of dividends
4 marks
- Time to write
- About 8 minutes
From an older CBCS paper
Question
Question 4 (a) · 4 marksDiscuss the Modigliani and Miller approach on the irrelevance of dividends. 4
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- DiscussEach point named and explained, not just listed.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 The proposition 1 mark 2 min
- 2 Assumptions 1 mark 1 min
- 3 The arbitrage argument and formula 1½ marks 2 min
- 4 Criticism ½ mark 2 min
Try it first. About 8 minutes for 4 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
The proposition. Modigliani and Miller hold that, given its investment policy, a firm's dividend policy does not affect the value of its shares or the wealth of its shareholders. The value depends on the earning power of the firm's assets, that is, on its investment decision, not on how the earnings are split between dividends and retained earnings.
1The dividend goes out one window, fresh shares are issued at the other—the firm's value stands still.
Paying the dividend is balanced by the new issueShareholders receive cash, but the issue of additional shares lowers the terminal value of their existing shares.
2The old investor counts it out: the share sits lower today by exactly the coins in his hand.
The price falls by the amount of the dividendThe year-end share price falls by exactly the dividend paid
3No dividend declared? He sells a few shares at the counter and makes his own.
Shareholders can make their own dividendsA shareholder who wants cash when no dividend is paid can sell some shares
Assumptions: perfect capital markets, rational investors and costless information; no flotation or transaction costs; a fixed investment policy; no investor large enough to affect prices; no taxes, or no difference between taxes on dividends and on capital gains.
The argument (arbitrage). If a firm with investment opportunities pays out its earnings, it must raise the same amount by issuing new shares. Whatever the shareholders gain in dividend is exactly offset by the fall in the share price that the new issue causes, so their total wealth is unchanged. Formally, P0 = (D1 + P1) ÷ (1 + ke): a higher D1 means a correspondingly lower P1.
Criticism. The assumptions are unrealistic: markets are imperfect; flotation and transaction costs exist; dividends and capital gains are taxed differently; and under uncertainty investors may prefer a certain dividend now (and read dividends as signals), so dividends may well affect value in practice.
Where the 4 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | The proposition | 1 |
| 2 | Assumptions | 1 |
| 3 | The arbitrage argument and formula | 1.5 |
| 4 | Criticism | 0.5 |
| Total | 4 |
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