Miller and Modigiliani position:

They have advanced a view that the value of the firm depends solely on the earning power and is
most influenced by the manner in which the earnings are split between dividends and retained
earnings.

Assumptions:
• Capital market is perfect and investors are rational.
• Flotation costs are nil.
• There are no taxes.
• Investment and dividend decisions are independent.

P0 = {1/(1+ρ) } * ( D1 + P1)

P0 = Market price at time 0

D1 = Dividend / share at time 1
P1 = Price per share at time 1
ρ = Discount rate applicable to the risk class
to which the firm belongs.

Value of outstanding equity share at the time 0 is

nP0 = {1/(1+ρ) } * (n D1 + nP1)

= {1/(1+ρ) } * [n D1 + (n+m)P1 –mp1]

n = Number of outstanding shares at time 0

m = Number of equity shares issued at time 1
at price price P1( prevailing price)
mP1 = I1 – ( X1 –nD1)

I1 = Total investment at the end of year 1

X1 = Net profit of the firm at the end of year 1

nP0 = {1/(1+ρ) } * (n D1 + nP1)

= {1/(1+ρ) } * [n D1 + (n+m)P1 –mp1]

={1/(1+ρ) } * [n D1 + (n+m)P1 – {I1 – ( X1 –nD1)}]
={1/(1+ρ) } * [n D1 + (n+m)P1 – I1 + X1 –nD1]

=={1/(1+ρ) } * [ (n+m)P1 – I1 + X1 ]

As D1 is not found in the equation n,m,P1,I1,X1 are independent of D1, Miller & Modgiliani
reached the conclusion that dividend decision is irrelevant for investment and the firm value.

It is interesting to note (n+m)P1 which is the equity value of the firm.

Z & co has 1000 shares and is selling at Rs10/- per share. That is n = 1000 & P0 = Rs10/-
Let X = Rs1000/- & I = Rs1100/-

If Z pays dividend of Re 1/- then D1 = 1

Its P1 will be Rs10/- as there is no addition in value of the capital. So the company has to issue
shares at Rs10/- . ( i.e) 111 shares .
(n+m)P1 = ( 1000 +111) * 10 = Rs11,110/-

If Z does not pay any dividend P1 =11. It will have to issue just 10 shares at Rs11/-
(n+m)P1 = (1000 +10) * 11 = Rs11,110/-

Dividend has not affected the value.

M & M approach had encountered the following criticism:

• Information about prospects of the company is well known by the dividend pay out.
• Under uncertainty current income is favoured against the future income.
• Higher dividend pay out lower the value of shares.
• Issue cost/ Transaction cost/ taxes are relevant.

Radical decision – if taxes are also incorporated then,

Sl.No Particulars Firm A Firm B

1 Next year price 120 105
2 Dividend 0 15
3 Pre tax pay off 120 120
4 Current price 102.86 101.43
5 Capital gain 17.14 3.57
6 Pre tax return (2)+(5)/4 16.67% 18.31%
7 Tax on dividend@20% - 3
8 Tax on capital gain 10% 1.714 0.357
9 Total post tax income 15.426 15.213
[(2) +(5)] – [(7)+(8)]
10 Post tax rates[(9)/(4)] 15% 15%

Even under the lesser assumption dividend irrelevance exists in a perfect capital market (Explain)

As an investor in India do you agree? Why or why not?

Reasons which influence in making dividend payments:

• Investor preferences for dividends.
• Class of investors/clientele effects.
• Information signaling.
• Funds required.
• Liquidity considerations.
• Access to external source of financing and cost associated.
• Control factors.
• Taxes.
• Legal requirements.
Normally adopted dividend policies:

• Stable dividend payout- Constant % of earning is paid out.

• Stable dividend but steadily changing dividends ratio – Constant rupee quantum as
dividend.
• Dividend as a residual payout.
• Constant proportion of equity is paid as dividend.

Form of payment of dividend:

• Cash payment.
• Bonus shares.