Dividend Decisions and Valuation of Firm: MM hypothesis | Commerce & Accountancy Optional Notes for UPSC PDF Download

Introduction

According to the MM hypothesis, in a perfect market, a firm's dividend policy is solely determined by its earning power, which is influenced by its investment policy. Earning power is not affected by how earnings are distributed between dividends and retained earnings.

To illustrate this, let's examine three scenarios a firm may encounter when deciding on dividends:

• When the firm has sufficient cash to pay dividends, distributing dividends reduces the firm's assets and, consequently, decreases shareholders' claims on the firm's assets. However, this does not result in a net loss or gain for shareholders, and their wealth remains unchanged.
• In the case of a cash shortage to pay dividends, the firm may issue new shares to finance dividend payments. In this scenario, two transactions occur. Firstly, existing shareholders receive cash, reducing their claims on the firm's assets without affecting their net wealth. Secondly, new investors purchase shares at a fair price in cash, transferring some of the claims of existing shareholders to the new shareholders. The fair price is determined by subtracting dividends paid to existing shareholders from the share price before dividend payment. Despite these transactions, the firm's overall value remains unchanged.
• These analyses highlight the independence of a firm's earning power from its dividend distribution method, as suggested by the MM hypothesis.
• In accordance with the MM hypothesis, within an ideal market, a company's dividend strategy is exclusively dictated by its earning capacity, which is shaped by its investment strategy. The distribution of earnings as dividends or retained earnings does not impact this earning capacity.

To illustrate, let's explore three scenarios a company might face when considering dividends:

• When the company possesses ample cash reserves for dividend disbursement, paying out dividends diminishes the firm's assets and, consequently, reduces shareholders' claims on these assets. However, this adjustment does not yield a net loss or gain for shareholders, leaving their wealth unaffected.
• In instances of insufficient cash reserves for dividend distribution, the company may opt to issue new shares to fund dividends. Here, two transactions unfold. Firstly, existing shareholders receive cash, diminishing their claims on the firm's assets without altering their net wealth. Secondly, new investors acquire shares at a fair price in cash, resulting in the transfer of some claims from existing shareholders to these new shareholders. The fair price is determined by subtracting dividends paid to existing shareholders from the share price before dividend distribution. Despite these transactions, the firm's overall value remains constant.
• These scenarios underscore the autonomy of a company's earning capacity from its dividend distribution strategy, as posited by the MM hypothesis.

• Now if the firm pays dividend of Rs. 45 per share it will entirely utilize its internal funds of Rs. 270 crore and it will have to raise Rs. 270 crore per capital expenditure by issue of new shares.
• The value of shares after paying dividend of Rs. 45 would be 330-45= Rs. 285
• The existing shareholders receive a cash of Rs. 45 and simultaneously suffer a capital loss of Rs. 45 in the form of reduced share value. The share holders nether gain nor lose. The firm will have to issue  270 crore/285  (94,73,684 lakh) shares. Now, the firm has 6+.9473685 crore shares at Rs. 285 per share. The value of the firm is 285><6.9473685cr= 1979.9999cr= 1980 crore.

• With the above example let us briefly discuss the central focal argument of MM hypothesis which is that the share holders are not merely dependent of dividends for obtaining cash they can do so by selling a part of their holdings which would be equivalent to the expected dividends. This homemade dividend does not dilute the net wealth of the investors. This is possible in perfect markets where there is absence of taxes, floatation cost and transaction cost.

Now, let us derive the MM hypothesis, which is based on the following assumptions.

• Ideal Capital Market: Ideal markets exhibit rational investor behavior, along with the absence of information disparities—where information is uniformly accessible to all participants. Transaction and flotation costs are nonexistent. In such a market, no individual buyer or seller possesses sufficient influence to sway the market price of securities.
• Tax Neutrality: Taxation is absent, encompassing both income and differential tax rates for capital gains and dividends. Consequently, investors remain indifferent to the form in which income is acquired—be it through capital gains or dividends.
• Defined Investment Strategy: Firms adhere to a predetermined investment policy, ensuring that investment opportunities and future profits are unequivocally known.
• Risk-Free Environment: Uncertainty concerning discount rates is absent, allowing for the precise forecasting of future prices and dividends. Moreover, a singular discount rate can be universally applied to all securities and time periods, leading to a consistent r=k=k_t for all periods.

In line with the aforementioned principles, the essence of MM's argument lies in the proposition that when a firm opts to retain earnings instead of disbursing them as dividends, the firm's share price appreciates by the amount of retained earnings per share. Conversely, if the firm chooses to distribute earnings as dividends, shareholders receive an income equivalent in value to the increase in share prices had the firm retained its earnings. This signifies that for shareholders, it holds no significance whether the firm retains earnings or distributes them as dividends. To substantiate their argument, MM initiates with a basic valuation model.

Where P₀= market price per share at time O
P_i= market price per share at time 1
D_i=dividend per share at time 1
k= discount rate applicable to the risk class to which firm belongs, this rate is assumed to remain unchanged.

Now as per the MM assumptions rate of return r is equal to discount rate k (identical for all shares); this would result into adjustment of share price so that the rate of return comprising of dividends and capital gains per share equals to the discount rate. The rate of return per share on share held for one year would be

Before proceeding further let us discuss why v which is rate of return is equal for all shares. If y is not equal for all securities the investors holding low-return-yielding securities will sell these securities and invest in high yielding securities. This process would lead to a lowering of the price of low yielding securities and increase in the price of high-yielding securities. This process which is known as switching or arbitrage is self propelled and will continue till the differential in rates of return is completely diminished to zero. Apart from rate of return the discount rate for all firms will also be same as there is no risk difference among the firms.

Now if the firm has access to external finance by issuance of (m) new equity shares at time 1 at a price of P₁ the value of the firm at time o would be

Equation 15.4 factors in issuance of new equity shares which is in contrast to Gordon’s and Walter's model. In MM model a firm can simultaneously pay dividends and raise funds by issue of new shares to undertake an optimum investment policy thus in this model the investment by firms can be either financed by retained earnings or by raising of capital by issuance of new shares.

Now, how is the quantum of new shares which are to be issued to finance investment is decided. For example is the firm’s investment requirements is Rs. 100 crores, its net profit is Rs. 80 crores and it wishes to distribute Rs. 50 crores as dividends then it will have to raise Rs. 70 crore. Put in mathematical form the equation for this calculation would be

where I₁ represents the total amount of investment during the first period and X₁ is the total net profit of the firm during period 1.
Substituting the value of mPi obtained in eq. in eq.  we get

In equation above D₁ is not anywhere and other variables (n+m), P₁, X₁ and I₁ are independent of Di; MM reached the conclusion that the value of the firm is not dependent on its dividend decision.

Before proceeding further few things should be noted.

• The MM dividend irrelevance hypothesis is an extension of MM ‘leverage irrelevance’ hypothesis. In the above derivation of MM dividend irrelevance hypothesis, it was assumed that the external finance is raised by issuance of additional equity; However even if the additional finance is raised by issuance of debt or combination of debt and equity it will have no impact on the final result as the real cost of debt and equity is same as per the MM leverage irrelevance hypothesis.
• The traditional approach to valuation the dividend capitalization approach is not in conflict with the MM hypothesis. As per the dividend capitalization approach the value of share/security is equal to the present value of the future stream of expected dividends. The MM hypothesis envisages that the dividend policy of a firm influences the timing and magnitude of dividend payments but these decisions cannot change the present value of the total stream of dividends.
• To sum up the MM’s argument that the dividend policy does not affect the wealth of share holders consider a firm having future investment plans and decides to pay dividends also implying that it has to raise additional funds to simultaneously carry out both of these. The advantage of paying dividends is offset by external financing. The terminal value of shares decline by the amount of dividends paid thus the wealth of the shareholders after payment of dividend and external financing is equal to the present value per share before the payment of dividends. This fact makes share holders indifferent to payment of dividends or retention of earnings.

Example: Silent and Humming Co. Ltd., currently has 3 lakhs outstanding shares with market price of Rs. 300 per share. The company has net profit of Rs. 90 lakhs and investment plans of Rs. 180 lakhs for the next year. The company wishes to declare a dividend of Rs. 45 per share at the end of the current year. The firms opportunity cost of capital is 10 per cent. What would be the price of the share if

• dividend is not declared
• dividend is declared
• how many new shares are issued to finance investment

Solution: i) The price of the share at the end of year when no dividend is paid

ii) The price of the share at the end of year when dividend is paid
P₁ = 300 (1.10)- 45 = Rs. 285
Note that in both the cases net wealth of the share holders remains unchanged
iii) Number of shares to be issued to finance new investment

Criticism of MM Hypothesis

• In a perfect capital market, rational investor behavior prevails, and there is no information asymmetry, ensuring that information is uniformly available to all market participants. Transaction costs and floating costs are non-existent, and no single buyer or seller holds enough influence to impact the market price of securities significantly.
• Taxation is absent in this ideal market, encompassing both income and differential tax rates for capital gains and dividends. Consequently, investors remain indifferent to the form in which income is acquired, whether through capital gains or dividends.
• Firms adhere to a predetermined investment policy in this setting, ensuring that investment opportunities and future profits are unequivocally known.
• There is no uncertainty concerning discount rates in this risk-free environment, enabling the precise forecasting of future prices and dividends. Moreover, a singular discount rate can be universally applied to all securities and time periods, leading to a consistent r=k=kt for all periods.
• Accordingly, MM's argument posits that when a firm chooses to retain earnings instead of disbursing them as dividends, the firm's share price appreciates by the amount of retained earnings per share. Conversely, if the firm opts to distribute earnings as dividends, shareholders receive an income equivalent in value to the increase in share prices had the firm retained its earnings. Thus, whether the firm retains earnings or distributes them as dividends holds no significance for shareholders. To substantiate this argument, MM begins with a basic valuation model.