Amity business school

1. Amity Business School
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Amity Business School
Financial Management

2. Amity Business School

3. Amity Business School
The Value of the firm is maximize by maximizing the wealth of the share holders
There are conflicting views regarding the impact of dividend declaration on the
Valuation of the Firm
There are two school of thoughts regarding Dividend declaration and its impact on the
Value of the firm. They are as follows:
1 Theory of irrelevance
2. Theory of Relevance
1. Irrelevance Theory
a.resIdual approach
b.ModIglIanI and MIllers approach

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resIdual Theory
According to this theory, Dividend decision has no impact on the
Wealth of the shareholder or the market price of the share and hence it
Is irrelevant so far the valuation of the firm is concerned.
This theory regards dividend decision merely a part of the financing
Decision because the earnings available may be retained in the
Business for the reinvestment. But if the funds are not required in the
Business it may be distributed as dividend.
Thus the decision to pay dividend or retained the earnings may be taken
As a residual decision.

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2. MODIGLIANI AND MILLER APPROACH (MM APPROACH)
According to the profounder of this theory The dividend policy has no effect on the
Market price of the share and the value of the firm is determine by the earning
Capacity of the firm or its investment policy. The division of the earning between
retention and dividend may be in any manner, it will have no impact on the value
Of the firm.
ASSUMPTIONS
a. There is perfect capital market
b. Investors behave rationally
c. Information about the company is available to all without any cost
d. There is no flotation and transaction cost
e. There are either no taxes or no difference in tax rates applicable to dividend &
capital gain
f. The firm has a rigid investment policy

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ARGUMENT
The argument given by MM is that what ever
increase in the value of the firm result
from the payment of the dividend, will be exactly off
set by the decline in the
Market price of the shares because of the external
financing and there will be no
Change in the total wealth of the shareholder

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P1 = P0 (1+ke) – D1
P1 is price at the end of the period
P0 is price at the beginning of the period
D1 is Dividend
m = [ I – (E –nD1)]
P1
m is the number of shares to be issued
I is the investment
E is the earning
D1 is the dividend
n is the no of outstanding shares at the
beginning of the period
V = (n+m)P1 – (I- E)
1+Ke
V is the value of the firm

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Question.
The cost of capital of z ltd is 10%. It currently has outstanding 5000 shares
Selling price is 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
Rs 50000 earnings and has a proposal for making new investment of Rs.100000
Prove under MM Hypothesis that payment of dividend does not have impact on the
Value of the Firm