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Dividend decision of the business concern is one of the crucial parts of the financial manager, because it determines the amount of profit to be distributed among shareholders and amount of profit to be treated as retained earnings for financing its long term growth. Hence, dividend decision plays very important part in the financial management. Dividend decision consists of two important concepts which are based on the relationship between dividend decision and value of the firm.
Fig. Dividend Theories
Irrelevance of Dividend
According to professors Soloman, Modigliani and Miller, dividend policy has no effect on the share price of the company. There is no relation between the dividend rate and value of the firm. Dividend decision is irrelevant of the value of the firm. Modigliani and Miller contributed a major approach to prove the irrelevance dividend concept.
Modigliani and Miller’s Approach
According to MM, under a perfect market condition, the dividend policy of the company is irrelevant and it does not affect the value of the firm. “Under conditions of perfect market, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firm’s investment policy, its dividend policy may have no influence on the market price of shares”.
MM approach is based on the following important assumptions:
Proof for MM approach
MM approach can be proved with the help of the following formula:
Po= Prevailingmarket price of a share.
Ke = Cost of equitycapital.
D1 =Dividend to be received atthe end of period one.
P1 =Market price ofthe share atthe end of period one.
P1 can be calculated with the help of the following formula
P1 = Po (1+Ke) – D1
The number of new shares to be issued can be determined by the following formula:
M * P1 = I – (X – nD1)
M =Number of new share to be issued.
P1 = Price at which new issue is to be made.
I =Amount of investment required.
X = Total net profit of the firm during the period.
nD1= Total dividend paid during the period.
X Company Ltd., has 100000 shares outstanding the current market price of the shares Rs. 15 each. The company expects the net profit of Rs. 2,00,000 during the year and it belongs to a rich class for which the appropriate capitalisation rate has been estimated to be 20%. The company is considering dividend of Rs. 2.50 per share for the current year.
What will be the price of the share at the end of the year
(i) if the dividend is paid and
(ii) if the dividend is not paid
(i) If the dividend is paid
Ke = 20%
D1 = 2.50
2.50 + P1 = 15 * 1.2
P1 = 18 – 2.50
P1 = Rs. 15.50
(ii) If the dividend is not paid
Po = 15
Ke = 20%
D1 = 0
Ram company belongs to a risk class for which the appropriate capitalization rate is 12%. It currently has outstanding 30000 shares selling at Rs. 100 each. The firm is contemplating the declaration of dividend of Rs. 6 per share at the end of the current financial year. The company expects to have a net income of Rs. 3,00,000 and a proposal for making new investments of Rs. 6,00,000. Show that under the MM assumptions, the payment of dividend does not affect the value of the firm. How many new shares issued and what is the market value at the end of the year?
Dividend is not declared
Ke = 12%, Po = 100, D1 = 0, P1 = ?
Calculation of number of new shares to be issued
Dividends not Paid
|Amount to be raised as new shares (Investment - Retained Earnings)||480000||300000|
Relevant - Market Price per share
No. of new shares to be issued
Total number of shares at the end of the year
(+) new shares issued
Market price per share
Market value for shares
There is no change in the total market value of shares whether dividends are distributed or not distributed.
ABC Ltd. has a capital of Rs. 10,00,000 in equity shares of Rs. 100 each. The shares are currently quoted at par. The company proposes to declare a dividend of Rs. 10 per share at the end of the current financial year. The capitalization rate for the risk class to which the company belongs is 12%.
What will be the MP of the share at the end of the year, if
(i) A dividend is not declared.
(ii) A dividend is declared.
(iii) Assuming that the company pays the dividend and has net profits of Rs. 5,00,000 and makes new investments of Rs. 10,00,000 during the period, how many new shares must be issued? Use the MM Model.
As per MM Model, the current MP of the share is
(i) If the dividend is not declared
(ii) If the dividend is declared
112 = 10 + P1
P1 = 112 – 10
P1 = Rs. 102
(iii) In case the firm which pays dividend of Rs. 10 per share, then the number of new shares to be issued is M.
M*P1 = I – (X – nD1)
M*102 = 10,00,000 – (5,00,000 – 10,000*10)
102 m = 10,00,000 – 4,00,000
= 5882.35 (or) 5883
The firm should issue 5883 new shares @ Rs. 102 per share to finance its investment proposals.
Z Ltd., has risk allying firm for which capitalization rate is 12%. It currently has outstanding 8,000 shares selling at Rs. 100 each. The dividend for the current financial year is Rs. 7 per share. The company expects to have a net income of Rs. 69,000 and has a proposal formatting new investments of Rs. 1,60,000. Show that under the MM hypothesis the payment of dividend does not affect the value of the firm.
(a) Value of the firm when dividends are paid. Price of the shares at the end of the current financial year
P1 = Po (1+Ke) – D1
= 100 (1 + .12) – 7
= 100*1.12 – 7
P1 = Rs. 105
(b) Number of shares to be issued.
The MM hypothesis explained in another firm also assumes that investment required by the firm on account of payment of dividends is finance out of the new issue of equity shares.
S = Value of the firm can be calculated as follows
TE =Total Earnings
M1 = Market Price atthe end ofthe period
Ke =Cost of capital
D = Dividend paid at the end of the year (or) period
N = Number of shares outstanding at the beginning of the period.
Criticism of MM approach
MM approach consists of certain criticisms also. The following are the major criticisms of MM approach.
MM approach assumes that tax does not exist. It is not applicable in the practical life of the firm.
MM approach assumes that, there is no risk and uncertain of the investment. It is also not applicable in present day business life.
MM approach does not consider floatation cost and transaction cost. It leads to affect the value of the firm.
MM approach considers only single decrement rate, it does not exist in real practice.
MM approach assumes that, investor behaves rationally.Butwe cannot give assurance that all the investors will behaverationally