Mm Approach

Qus4. What argon the assumptions of MM approach? Ans. Assumption of the MM approach The MM approach to irrelevancy of dividend is based on the following assumptions * The cap of the United States markets ar perfect and the investors roleplay rationally. * All information is freely available to all the investors. * There is no transaction cost. * Securities are divisible and can be split into either fraction. No investor can affect the market price. * There are no taxes and no flotation cost. The firm has a defined investment policy and the future profits are known with certainty. The implication is that the investment decisions are unaffected by the dividend decision and the operating cash flows are analogous 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 will be adversely affected by firms paying either too little or too much dividends.They have used the merchandise process to image that the division of profits between dividends and retained earnings is irrelevant from the heighten 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, and so will raise an equal amount of new share capital externally by selling new shares. The amount of dividends paid to animated shareholders will be replaced by new share capital elevated externally.In order to satisfy their model, MM has started with the following valuation model. P0= 1* (D1+P1)/ (1+ke) Where, P0 = turn in 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 dish up of this valuation model we will create a arbitrage process, i. e. , replenishment of amount paid as dividend by the issue of fresh capital.The arbitrage process i nvolves 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 whatsoever effect on the range 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.