Depends solely on its earnings power is not

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depends solely on its earnings power & is not influenced by the manner in which its earnings are split between dividends & retained earnings. Assumptions : Capital markets are perfect and investors are rational; information is freely available, transactions are instantaneous & costless, securities are divisible. Floatation costs are Nil There are no taxes Investment opportunities & future profits of firms are known with certainty Investment & dividend decisions are independent
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MM argument : If a company retains earnings instead of giving it out as dividends, the shareholder enjoys capital appreciation equal to the amount of earnings retained If it distributes earnings by way of dividends instead of retaining it, the shareholder enjoys dividends equal in value to the amount by which his capital would have appreciated had the company chosen to retain its earnings Hence the division of earnings between dividends & retained earnings is irrelevant from the point of view of shareholders.
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MM valuation model where P 0 = Mkt. price per equity share at time 0 D 1 = dividend per share at time 1 P 1 = mkt. price per equity share at time 1 r = discount rate applicable to the risk class (constant ) to which the firm belongs n = no. of shares at time 0 1 ( 1 + r ) P 0 = ( D 1 + P 1 ) Eqn - 1
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MM valuation model Let X 1 be the Net profit of the firm in year 1 & I 1 be the investment by the firm in year 1 Funds to be raised to meet investment needs Assume ‘m’ shares are issued at P 1 price in year 1 to fund requirements of capital investments Funds to be raised to meet investment needs 1 1 1 1 mP nD X I 1 1 1 nD X I
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MM valuation model where n = no of outstanding equity shares at time 0 nP0 = total market value of equity shares at time 0 m = no of equity shares issued at time 1 at price P1 mP1 = mkt. value of equity shares issued at time 1 (n+m)P1 = total mkt. value of all equity shares at time 1 r = discount rate applicable Eqn - 2 1 1 1 0 1 1 nP mP P m n nD r
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MM valuation model Substituting the value of mP 1 in eqn 2, Eqn - 3 From the above equation, it is noted that the value of equity at the end of year 1, (n+m) P 1 , is no way affected by Dividend paid in year 1 1 1 1 0 1 1 nP X I P m n r
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1. The firm’s value is determined solely by the earning power and risk of its asset investments. 2. If dividends do affect value, they do so because of the information content , which signals management’s future expectations. 3. A clientele effect exists that causes shareholders to receive the level of dividends they expect. Arguments for Dividend Irrelevance In summary, MM and other dividend irrelevance proponents argue that all else being equal —an investor’s required return, and therefore the value of the firm, is unaffected by dividend policy because:
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Numerical illustration of MM irrelevance theorem Free Cash flow to firm (FCFF) FCFF = EBIT(1- t c ) Reinvestment needs g WACC g FCFF 1 firm of Value
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