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What are the assumptions of Miller and Modigliani's Dividend Irrelevance Model?
Like Walter’s model and Gordon’s model, the Miller and Modigliani model also rests upon some assumptions. The MM model is much celebrated one due to the flexibility and exclusiveness of the theories included, which are discussed below.
Perfect Capital Markets
The MM model considers the capital markets to be perfect. This means that the markets have all rational investors. By rational, it means that all investors in the market tend to be risk averse and want to earn the maximum profits from investing in the markets.
There is always a fair competition in the markets which means that all investors have the relevant information that may affect decisions of shareholding patterns. Therefore, all investors in the market should make decisions depending on related and necessary information.
There is also no floatation and transaction costs in a perfect capital market. This means that no investor has to pay an extra amount to buy or sell the shares. It is relevant because if there is a palpable transactional and floatation cost, the pricing would affect the market’s operations and on the total budget of the shareholders.
The MM model also considers that there is no tax applicable to dividends. This means that there are no taxes applicable to capital gains or the dividends. No taxation means there is no additional cost that investors have to bear when they get the dividends from a firm. Therefore, the value of a rupee of dividends is equal to one rupee of capital gains.
According to the MM model, the firm for which the dividend policy is considered should have a fixed investments policy. Therefore, a firm should not change its investment policies every now and then when the investment-decisions need to be altered.
This means that for a given firm, the risks and uncertainties do not exist. The investors in such a situation can predict the future earnings with certainty and relevance. This is an important assumption because it makes the markets where shares are held a perfect one as mentioned in the first hypothesis of the model.
Moreover, according to the MM model, one discount rate is applicable to all securities and all tenures of investments. This means that all securities are discounted at a given rate, making the prediction of the share-prices possible for the investors in the market.
The MM hypothesis is a standard policy of understanding the behavior of dividend valuation. It solves the pertinent issues related to dividend yield and valuation. However, it is not a perfect theory for investors because most of the assumptions of the theory are either inapplicable or wrong in practical situations.
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