Question

1. Rea Vipingo Limited has a cost of equity of 10%. Currently it has 500,000 ordinary shares which are quoted at the stock Exchange at $120 per share. The company’s earnings per share is $ 10 and it intends to maintain a dividend payout ratio of 50% at the end of the current financial year. The expected net income for the current year is $6 million and available investment proposals are estimated to cost $12 million.

           Required:

1. Using the Modigliani and Miller (MM) model, show that the payment of dividends does not affect the value of the firm.
2. What are the assumptions inherent in the MM Model?

Answer 1

1. Cost of equity = 10%

Equity shares = 500000×120 = $60 million

EPS =10

DIVIDEND PAY OUT RATIO = 50%

Net income = $6 million

Value of equity = Net income for equity share holder/ cost of equity

= 60,00,000/10%

= 60 Million dollars = value of firm

So, whether to pay dividend or not, it does not effect value of firm.

2. Assumptions inherent in MM model:

• The capital markets are perfect and complete information is available to all the investors free of cost. The implication of this assumption is that investors can borrow and lend funds at the same rate and can move quickly from one security to another without incurring any transaction cost.
• The securities are infinitely divisible.
• Investors are rational and well informed about the risk return of all the securities.
• All the investors have same probability distribution about the expected future earnings.
• There is no corporate income tax ( this assumption was relaxed later).
• The personal leverage and corporate leverage are perfect substitute.