Question
Explain the Modigliani-Miller (MM) hypothesis on dividend policy. Under what
assumptions does dividend policy become irrelevant to the value of a firm?
Answer :
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The Modigliani-Miller (MM) hypothesis on dividend policy is a significant theory in financial management that explains the relationship between a firm’s dividend decisions and its market value. Proposed by Franco Modigliani and Merton Miller, the theory states that under certain ideal market conditions, dividend policy is irrelevant to the value of a firm. According to MM, the value of a firm depends primarily on its earning capacity and investment decisions rather than on how earnings are divided between dividends and retained earnings. The MM hypothesis is based on the principle of dividend irrelevance. When a firm earns profits, it can either distribute them to shareholders as dividends or retain them for financing future investments. MM argues that, if the firm’s investment policy remains unchanged, shareholders will be indifferent between receiving dividends and earning capital gains through reinvestment of profits. The market value of the firm is therefore determined by its investment and earning decisions, not by its dividend policy. According to MM, the value of a firm can be expressed as the present value of its future earnings. If a company pays a dividend, it may have to raise additional funds to finance its investment projects. The issue of new shares to raise such funds can reduce the ownership proportion of existing shareholders. However, the wealth received by shareholders through dividends is compensated by the reduction
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