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

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.

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

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

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

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

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:

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