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The term dividend refers to that part of profits of a company which is distributed by the company
among its shareholders. it is the reward of the shareholders for investments made by thern in the shares
of the company. The investors are interested in earning the maximum retum on their investments and
to maximise their wealth. A company, ofl the other hand, needs to provide funds to finance its long-
term growth. If a company pays out as dividend most of what it earns, then for business requirements
and further expansion it will have to depend upon outside resources such as issue of debt or new shares.
Dividend policy of a finn, thus affects both the iong-tenn financing and the wealth of shareholders. As
a result, the firm's decision tp pay dividends mrist be reached in such a manner so as to equitably
apportion the distributed profits and retained eamings. Since dividend is a right of shareholders to
pirticipate in the profits and surplus of the cornpany for their investment in the share capital of the
Lo*puny, they siiould reccive fair amount of the profits. The company should, therefore, distribute a
reasonable amount ris dividends (which should include a normal rate of interest plus a return for the risks
assumed) to its members and retain the rest for its growth and survival.

MEVISffiE{F DEEISEOS'AI{P'VALUA?TOH OF' TIR.MS

The value of the firm can be maximised if the shareholders' wealth is maximised. There are
conflicting views regarding the impact of dividend decision on the valuation of the firm. According to
one school of thought, dividend decision does not affect the share-holders' wealth and hence the
valuation of the firm. On the other hand, according to the other school of thought, dividend decision
rnaterially affects the shareholders' wealth and also the valuation of the firm.
We have discussed below the views of the two schools of thought under two groups :
L The Irrelevance Concept of Dividend or the Theory of Irrelevance, and
2. The Relevance Concept of Dividend or thc Theory of Relevance.

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A. RESIDUAL APPROACH
According to this theory, dividend decision has no effect on the wealth of the shareholders or the
1;1,2 ", Dividend.Theorias,Policy'andDecision

prices of the shares, and henceit is inelevant so far as the valuation of the firm is concerned. This theory
regards dividend decision merely as a part of financing decision because the earnings available may be
retained in the business for re-investment. But, if the funds are not required in the business they may
be distributed as dividends. Thus, the decision to pay dividends or retain the earnings may be taken as
a residual decision. This theory assumes that investors do not differentiate between dividends and
retentions by the firm. Their basic desire is to earn higher return on their investment. In case the hrrn
has profitable investment opportunities giving a higher rate of return than the cost of retained earnings,
the investors would be content with the fim retaining the earnings to finance the same. However, if the
firm is not in a position to find profitable investment opportunities, the investors would prefer to receive
the earnings in the form of dividends. Thus, a finn should retain the eamings if it has profitable
investment opportunities otherwise it should pay them as dividends.

B. MODIGLIANI AND MXLLER ,{PPROACH (MM MODEL)

Modigliani and Miller have expressed in the most comprehensive manner in support of the theory of
irrelevance. They maintain that dividend policy has no effect on the market price of the shares and the
value of the finn is determined by the eaming capacity of the fitm or its investment policy. The splitting
of earnings between retentions and dividends, may be in any manner the firm likes, does not affect the
value of the firm. As observed by M.M. "Under conditions of perfect capital markets, rational investors,
absence of tax discrimination between dividend income and capital appreciation, given the firm's
investment policy, its diviclend policy may have no influence on the market price of the shares."r

Assumptions of MM Hypothesis

The MM hypothesis of irrelevance of dividends is based on the following assumptions :

O There are perfect capital markets.

(iil Investors behave rationallY.
(iii) Information about the company is available to all without any cost.
(iv) There are no floatation and transaction costs.
(vl No investor is large enough to effect the market price of shares.
(vi) There are either no taxes or there are no differences in the tax rates applicable to dividends
and capital gains.
(vii) The firm has a rigid investment poiicy.
(viii) There is no risk or uncerlainty in regard to the future of the firm. (MM dropped this
assumption later).

The Argument of MM
The argument given by MM in support of their hypothesis is that whatever increase in the value
of the hrm results from the payment of dividend, will be exactly off set by the decline in the market
price of shares because of external financing and there will be no change in the total wealth of the
shareholders. For example, if a company, having investment opporhrnities, distributes ali its earnings
among the shareholders, it will have to raise additional funds from external sources. This will result in
the increase in number of shares or payment of interest charges, resulting in fall in the earnings per share

l. Miller, M.H. and F.Modigliani, " Dividend Policy, Growth and Valuation of Joumal of Business, October 1961.
 Diivide;nid Theories; Poli-a11 and, Deeision .' 10.3

in the future. Thus whatever a shareholder gains on account of dividend payment is neutralised
earnings per share"
completely by the fall in the market price of shares due to decline in expected future
to the present value
To be more specific, the market price of a share in the beginning of a period is equal
of the period.
of dividends paid at the end of the period plus the market price of the shares at the end
This can be put in the lorm of the following formula :

,n-D' +P'
1+K.
Where Po: Market Price Per share at the beginning of the period, or prevailing market price of

Dl : ;,t:;t , to be received at the end of the period'

F, : Ivlarket price per share at the end of the period.
Ke:Costofequitycapitalorrateofcapitalisation'
The value of P, can be derived by the above equation as under :

P,: Po (l+ke) -D,

that investment required by
The MM hypothesis can be explaineil in another fonn also presuming
issue of equity shares'
the firm on account of payment of dividends is financed out of the ner,v
the following
In such a case, the number of shares to be issued can be computed with the help of
equation:

* =-n,
I (E_nDl)

Further, the value of the firm can be ascertained with the help of
the following formttla :

- (n+m)P1-(l-E)
nPo=--i;-
Where, m: number of shares to be issued'

I - Investment required.
E: Total earnings of the firm during the period'
Pr:Marketpricepershareattheendoftheperiod'
Ke : Cost of equity caPital.
n : number of shares outstanding at the beginning of the period'
D, : Dividend to be paid at the end of the period'
flPo: Value of the firm
of dividend to the
Let us take the following illustration to illustrate MM hypothesis of irrelevance
valuation of fim.
rate is 10%'
Itlustration l. ABC Ltd. belongs to a risk class for which the appropriate capitalisation
the declaration
It currently has outstanding 5,cc0 shares selling at {100 each. The firm is contemplating
expects to have a net
of dividend of {6 per share at the end of the current financial year. The company
{1,00,000. Show that under the
income of {50,000 and has a proposal for making new investments of
MM hypothesis, the payment of dividend does not effect the value of the firm'
101 e.',,'Di,vidend,Theories, P,ggE"yi,nd,Deelsian

Solution :

(A) Value of the firm when dividends are paid :

(i) Price ofthe share at the end ofthe current financial year
P, : P" (l+ke) - D,

:l33ri lt'j
:ll0-6:{104
(i, Number of shares to be issued
I- (E- nDr
ln =-- )

Pt

_ 1, 00,000 - (50, 000 - 5, 000 x 5)

104

_ 80,000
104
(ii) Value of the firm

nP _(n+m)Pr-(1*E)
1+ke

fr,ooo - ry+Pj x 104 - (1,oo,ooo - so,ooo)

_\ 104 )
1+.10

5.20.000+80.000 lM
_104r
1.10

5,C0,000 - 50,000
1.10

=''lol9oo = { 5,oo,ooo.
1.10
(B) Value of the firm when dividends are not paid :

(i) Price per share at the end of the curent financial year
Pr = Po (l+ke) - D,
: 100 (1+.10)-0
=l00xl.l0: <110
(ii) Number of shares to be issued

_ I-(E- nDt)
m
Pl

1,00,000*(50,000-0)
110

50,000
110
(iii) Value of the firm

nPo _(n+m)Pr-(I-E)
1+ke

(s,ooo *4'0001 x r. ro - (1, 00,000 s0,000)

-
_\
-
110 ) i

l.l0 it
j
,'E
 DiuidendTheories,Paliey a,id:,O6Cisron . {0"5

5,50,000+50,000 l10
x -50.ooo
110 I

6,00,000 - 50,000
l.r 0

= { 5,00,000.
Hence, whether dividends are not, the value of the firm remains the same {5,00,000.

trllustration 2. Expandent Ltd. had 50,000 equity shares of {10 each outstanding on January 1. The
shares are currently being quoted at par in the market. In the wake of the removal of dividend restraint,
the company now intends to pay a dividend of (2 per share for the current calendar year. It belongs
to a risk-class whose appropriate capitalisation rate is 15%. Using MM rnodel and assuming no taxes,
ascertain the price of the company's share as it is likely to prevail at the end of the year (l when
dividend is declared, and (ii) when no dividend is declared. Also find out the number of nerv equity
shares that the company must issue to meet its investment needs of {2 lakhs, assuming a net income
of (1.1 lakhs and also assuming that the clividend is paid.

Solution:

(, Price per share when dividends are paid

P, Po (l+ke) - D,
l0 (l+.15)-2
11.51= T 9.5
(ii) Price per share when dividends are not paid :

Pi : Pn (l+ke) * D,
l0 (l+.1s)-0
t 1l.s
(ii, Number of new equity shares to be issued if dividend is paid
I_ (E_ nD1)
Pl

_ 2, 00, 000 - (1, 10, 000 - 50, 000 x2)

9.5
l'90'ooo
- = 2o.ooo shares
9.5

Criticism of MM Approach
MM hypothesis has been criticised on account of various unrealistic assumptions as given below.
1. Prefect capital market does not exist in reality
2. Infonnation about the cornpany is not available to all the persons.
3. The firms have to incur flotation costs while issuing securities.
4. Taxes do exit and there is normally different tax treatment for dividends and capital gains.
5. The firms do not follow a rigid investment policy.
6. The investors have to pay brokerage, fees, etc. while doing any transaction.
7. Shareholders may prefer current income as compared to further gains.