Question

1. Explain, with the aid of a diagram, how a firm’s dividend policy is independent from its investment policy in a perfect and complete world

Answer 1

First, Modigliani and Millar have found that dividend is irrelevant in investment decision in 1921. The dividend policy has no effect on valuation of company subject to certain assumptions regarding perfect market. The concept says that valuation of company depends on earning capacity of firm and business risk.

Assumptions

1. There is perfect capital market.

2. There is no transaction or floatation cost.

3. There is not taxes ( personal and corporate both)

4. The capital structure does not affect cost.

5. All informations are free available to the public.

6. The cost of equity is constant regardless of dividend payout.

7. The dividend policy does not affect capital budgeting decisions.

Diagram

As per the concept, dividend is irrelevant as it does not affect cashflow of investor. If investor perceives dividend is too high, he will purchase additional stock from such excess dividend, if investor perceives divided is too low, he will sale some stock to generate additional cashflow. Thus, dividend is irrelevant because investor can manage their cashflow.

We have also found supporting proof from arbitrage mechanism. Subject to existence of perfect market, dividend results in reducing the share price. Reduction is equal to dividend amount.

For Example, ABC Ltd. Share is traded for $100. He ABC Ltd. Declared dividend of $10. The share price of ABC Ltd. Wil dropped up to $90. Hence, Income arising from dividend is offset by reduction in share price. Actually, dividend payout reduces retained earnings and adversely affect future growth of company. Dividend is irrelevant in investment decision.