miller modigilani dividend model

Miller Modigilani Dividend Model – Full Explanation

Miller Modigilani Dividend Model – The model states that under the perfect market situation , the dividend policy of the firm is irrelevant as it does not affect the value of the firm.

The model further argue that value of the firm depend upon the earnings of the organisation which is the result of enterprise investment policy. So, MM dividend model argues that dividend decision or pay out ratio does not affect the value of the firm.

A firm operating in perfect capital market condition face one of the following three situations with respect to the payment of dividends-

  • The firm has sufficient firm to pay off the dividends to shareholders.
  • Firm does not have sufficient cash to pay the dividends and hence it issues new shares to finance the payment of dividends.
  • The firm does not pay dividends, however shareholders need cash.

Situation 1 – When the organisation pay dividend to shareholders, they get cash in their hands. On the other hand the cash with the firm declines meaning thereby the assets of the firms declines. So whatever shareholders get in form of dividends, they on the other hand lose their claim on the assets. So there is transfer of money from one pocket of shareholder to another.

Situation 2 – When the firm issue new shares, two transactions takes place. First transaction is explained in Situation 1. In second transaction, new shareholder gives money to company and in return get share at a certain price. The existing shareholder transfers a part of their claim to new shareholders in exchange of cash.

Situation 3 – In third situation, firm do not pay any dividend. So shareholders can sell the shares they are holding for a fair price and enjoy cash or income they need.

Miller Modigilani Dividend Model Assumptions

  • The enterprise operates in a perfect capital markets. Information is readily available and investors behave rationally. There is no investor that will affect the market to a large extent.
  • There are no taxes.
  • Firms have fixed investment policy.
  • There is no risk or uncertainty.

So according to MM Dividend model, rate of return that is r will be equals to –

r = [Dividends + Capital gains (loss)]/ Share Price

= [DIV + (P1 – P0)]/P0

As MM Dividend Model hypothesis, r should be equal for all shares. But if it is not equal, the low return yielding shares will be sold by investors who will purchase high return yielding shares. This process will continues till r of all shares does not become equal. This is called switching or arbitrage.

Related Financial Terms of Miller Modigilani Dividend Model