Question

State the dividend irrelevance proposition. What are the assumptions behind this proposition? Explain why this proposition does not hold in the real world.

Answer 1

Dividend Irrelevance theory/Proposition- M.M Approach

Dividend Irrelevance Proposition has supported the irrelevance of dividends it means that the entity's dividend policy does not effect the price of the stock or its cost of capital.

Assumptions of the Dividend Irrelevance theory.
Perfect Capital Markets
No Taxes
No Floatation cost
Risk of Uncertainty does not exist

According to MM hypothesis
Market value of equity shares of its firm depends solely on its earning power and is not influence by the manner in which its earnings are split between dividends and retained earnings.

Market value of equity shares is not affected by dividend size.
MM hypothesis is primarily based on the arbitrage argument. Through the arbitrage process, MM hypothesis discusses how the value of the firm remains same whether the firm pays dividend or not. Here
Where,P0= P1+D1/1+Ke
Pₒ= Price in the beginning of the period. P₁= Price at the end of the period.
D₁= Dividend at the end of the period.
Ke= Cost of equity/ rate of capitalization/ discount rate.

As per MM hypothesis, the value of firm will remain unchanged due to dividend decision. This can be computed with the help of the following formula:

(n+ Δn)P1 - I+ E /(1+Ke )= Vf or nP₀

Where,

Vf   =   Value of firm in the beginning of the period
n   =   number of shares in the beginning of the period
∆n   =   number of shares issued to raise the funds required
I   =   Amount required for investment
E   =   total earnings during the period

Advantages of MM Hypothesis

this model is logically consistent
It provides a satisfactory framework on the dividend policy with the concept of arbitrage process.

Limitations of MM Hypothesis

Validity of Various assumptions is questionable
This model may not be valid under uncertainity.