Question

Explain M&M Proposition I and M&M
Proposition II in (just) 1 A4 page.

Critically evaluate the relationship between
dividend and firm value in the next A4 page.

Maximum total answers are two A4 pages (around
1,000 words total)

Answer 1

­­­­­­­­Modigliani and Miller approach

Irrelevance of dividends theory was provided by Modigliani and Miller. They argue that company's dividend policy has neither effect on its value of assets nor on shareholders wealth.

Their theory states that in condition of perfect capital markets, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the company’s investment policy, its dividend policy may have no effect over the price of shares of company.

Proposition-1 Related with value of company

Without Tax

Value of Unlevered company= Value of geared company

For Unlevered company= Company has only Equity in its capital structure have no debt.

For Geared company= Company has both debt and equity in its capital structure.

This approach state that both company’s whether levered or unlevered have same value. It state that one investor buy one share by its own money in unlevered company will have same value with the value of levered company if investor has purchased share of levered company by borrowing money.

This approach assumes that company will borrow at the same rate by which investor borrow money.

With Tax

Value of Ungeared company+ Value of Debt X tax rate = Value of geared company

This state the Geared Company has more value than value of ungeared company as it has benefit of taxation on interest amount on borrowed amount of geared company.

Proposition-2 Related with return of company

Without Tax

Return of geared company= return of ungeared company+ Debt/equity (Return of equity(ungeared)- return of Debt)

If investor has purchase share of levered company by borrowing money at the same rate as of levered company than return will be same.

With Tax

Return of levered company = Return of unlevered company+ Debt/ Equity (Return of unlevered company- Return on debt)(1- Tax Rate)

This approach assumed that return of levered company will have more return as it has tax benefit over interest expenses whereas dividend does not have benefit of taxes.

Critical evaluation Relation with Dividend and firm value

Assumption of this approach

1. Investor deals in perfect market.
2. There are no taxes or there is no difference in tax rates related with capital gains and dividends.
3. Investment policy is fixed.
4. No transaction cost.
5. No risk of uncertainty.

Price of share as per MM approach

Prevailing market price of a share=

(Market price at the end of period+ dividend to be received at the end of period)

(1+ Cost of Equity)

MM approach basically depends on one arbitrage opportunity i.e. whether firm declares dividend or not firm’s value remains same.

This approach argues that when firm pays dividend its value of share declines. Hence it would be same as shares price when firm does not pay dividend.This approach states that firm can use its amount of dividend for financing of other proposals of investment. if firm declares dividend and use option of issue of new shares for financing it will reduced the value of shares in the market. Further dividend + current market price of share would be same as market price before declaring the dividend.