Mm Approach

Qus4. What argon the assumptions of MM approach? Ans. Assumption of the MM approach The MM approach to irrelevance of divid peculiarity is ground on the following assumptions * The capital markets are perfect and the investors be energise rationally. * All information is freely available to all the investors. * There is no transaction cost. * Securities are divisible and can be split into any fraction. No investor can affect the market price. * There are no taxes and no flotation cost. The incorruptible has a defined investment polity and the future profits are known with certainty. The implication is that the investment decisions are unaffected by the dividend decision and the operate cash flows are same no matter which dividend policy is adopted. The model Under the assumptions stated above, MM argue that neither the firm paying dividends nor the shareholders receiving the dividends leave behind be adversely affected by firms paying either too little or too much dividends.They have used the arbitrage demonstrate to show that the division of profits between dividends and retained earnings is irrelevant from the point of view of the shareholders. They have shown that given the investment opportunities, a firm will finance these either by ploughing back profits of if pays dividends, then will raise an equal amount of new share capital outwardly by selling new shares. The amount of dividends paid to existing shareholders will be replaced by new share capital raised externally.In order to live up to their model, MM has started with the following valuation model. P0= 1* (D1+P1)/ (1+ke) Where, P0 = Present market price of the share Ke = Cost of equity share capital D1 = Expected dividend at the end of year 1 P1 = Expected market price of the share at the end of year 1 With the help of this valuation model we will stimulate a arbitrage process, i. e. , replacement of amount paid as dividend by the issue of fresh capital.The arbitrage process involves two simultaneous actions. With reference to dividend policy the two actions are * Payment of dividend by the firm * Rising of fresh capital. With the help of arbitrage process, MM have shown that the dividend payment will not have any effect on the lever of the firm. Even if the firm pays dividends, resulting in a increase in market value of the share, the effect on the value of the firm will be neutralised by the decrease in terminal value of the share.