Modigliani and Miller (MM) Model. The genesis of the Dividend Irrelevance Theory of Modigliani and Miller may be traced back to the “Capital Irrelevance Model’ advocated by them in a paper published in 1958. Under the above model, a was held that the capital structure of a company has no relevance as far as its future outlook is concerned. The above paper was followed by another paper published in 1961, wherein they came up with an entirely innovative idea, according to which the investors need not bother about the payment/non-payment of dividends from a company, in which they have an investment (of course subject to certain presumptions). Under the MM Model, a view was held that for the investors the ‘dividends’ and ‘capital gains” were nothing but the ‘returns’ on their investment. The value of a company, therefore, hinges upon its earnings. which is the outcome of its:
1) Investment policy/decisions, and
2) Overall performance of the industry, in which the company is engaged.
The dividend policy of a company has nothing to do with its valuation. The information, an investor is required to have about a company, for the purpose of making a decision relates to the company’s investment policy and the performance in that particular industry.
Dividend Policy and their Types- Click Here
The theory goes on to explain why investors are apathetic when it comes to dividend payouts. Based on this model, investors could have their own cash-flow information system for the stocks they own, based on how much cash they need, regardless of whether the stocks they own pay dividends or not.
If an investor has a dividend-paying share in their portfolio but does not need the money right now, the dividend proceeds would be reinvested in shares (of the same or another company). Similarly, if an investor in a company that does not pay dividends needs cash, he can sell a portion of his stock holdings.
Types of Dividends – Click here
Assumptions of Modigliani and Miller Model
There are certain assumptions (mentioned below), on which the MM model of irrelevance is based:
1) Perfect Capital Markets:
A company manages its business in a perfect capital market.
* A perfect capital market involves:
i) Behaviour of investors needs to be reasonable and logical.
ii) It should have transparency, i.e., any information searched for should be easily
available.
iii) There should not be a transaction/floatation cost.
iv) No single investor should be big enough to influence the price of a share.
2) No Taxes:
Taxes are either non-existent or the tax rates applicable to ‘Capital Gains’ and ‘Dividends” are the same. For an investor, the value of a rupee received as a dividend payout should not be different from the value of a rupee received as a capital gain.
3) Fixed Investment Policy:
Every company has a fixed long-term ‘Investment Policy”.
4) No Risk:
There are no elements of underlying risks regarding uncertainty.
Modigliani and Miller Formula for Determining the Value of a Share
The following formula is used to determine the market price of a share:
Po = D₁ +P1/ 1 + ke
Where, Po = Market price per share at the of the period, or prevailing market price of a share
D₁ = Dividend to be received at the end of the period
P₁ = Market price per share at the end of the period
Ke = Cost of equity capital or rate of capitalization
The value of P1, can be derived by the above equation:
P₁ = Po (1 + Ke) – Di
There is another way of explaining the MM hypothesis:
It is presumed that the investment requirements of a company on account of dividend payouts are financed out of the fresh issue of equity shares.
Following formula may be applied to calculate the number of shares required to be issued by the company:
m= I-(E-nD1,)/ P1
Further, the company’s value may be obtained with the help of the following formula:
nPo = (n+m)P1, -(I-E) / 1+ Ke
Where,
m = Number of shares to be issued
I = Investment required q
E = Total earnings of the firm during the period
P₁ = Market price per share at the end of the period
ke = Cost of equity capital
n = Number of shares outstanding at the beginning of the period
D₁ = Dividend to be paid at the end of the period
nPo = Value of the firm.