Question 4 OR (a)

MM's dividend irrelevance and its limitations

6 marks

Time to write: About 12 minutes
Topic: Dividend theories and dividend policy

Question

Question 4 OR (a) · 6 marks

Explain, along with its limitations, the MM approach of the irrelevance of dividend to the value of firm.

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

12 minfor 6 marks

Read from the question

ExplainEach point stated, then explained in a line or two.

Write it in this order

Read; underline the asks; jot your points 1 min
1 MM approach and assumptions 2 marks 3 min
2 Argument of irrelevance 2 marks 3 min
3 Limitations 2 marks 3 min
Check: every ask answered, key terms underlined 2 min

123

Short on time? Trim steps 1–3 evenly rather than skip one: each is capped at its own marks.

Try it first. About 12 minutes for 6 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 MM approach. Modigliani and Miller argue that, given the firm's investment policy, dividend policy does not affect the value of the firm; value depends only on the firm's earning power and investment policy.

Picture itMM's dividend irrelevance and its limitations

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; information free and available to all; no flotation or transaction costs; a fixed investment policy; no investor large enough to affect the share price; and no taxes, or no difference between the taxation of dividends and capital gains.

The argument. If a firm with investment opportunities pays its earnings out as dividends, it must raise the same amount from outside by issuing new shares. Whatever the shareholder gains from the dividend is offset exactly by the fall in the share price that follows, so total wealth is unchanged. The price is P0 = (D1 + P1) ÷ (1 + ke): a higher D1 means a correspondingly lower P1. Investors are therefore indifferent between dividends and capital gains.

Limitations (criticism)

Perfect capital markets do not exist in reality.
Information is not available to all persons, or not free.
Flotation costs: firms incur costs in issuing new securities, so outside finance costs more than retained earnings.
Taxes exist, and dividends and capital gains are usually taxed differently.
Investment policy is not rigid in practice.
Transaction costs: investors pay brokerage and fees when they buy or sell shares, so home-made dividends are not costless.
Investors may prefer current income to future gains (the bird-in-hand argument).

Because these assumptions do not hold, dividends can affect the value of the firm in practice.

Where the 6 marks sit

#	Component	Marks
1	MM approach and assumptions	2
2	Argument of irrelevance	2
3	Limitations	2
	Total	6

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