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What is Miller Modigliani's hypothesis about Dividend Irrelevance?
Miller and Modigliani’s dividend irrelevance model is one of the most used principles of dividend valuation. It states that a firm’s dividend payout is not relevant to the valuation of a firm. The value of a firm will remain the same even when the dividends are paid or held by the company for an infinite number of years.
Miller and Modigliani suggested that in a perfect share market, the dividend policy is irrelevant. They proposed that the dividend policy of a company has no effect on the stock price of a company or the company’s valuations.
There are mainly two hypotheses that sum up the MM model of dividend valuation −
Shareholders can earn homemade dividends by selling the shares
No arbitrage can be exercised by selling the shares
The Homemade Dividend Model
Miller and Modigliani’s dividend irrelevance theory is sometimes known as the homemade dividend theory. It suggests that a shareholder can earn as much money as in the case of dividend by selling the shares in the market. Hence, the investors are indifferent to the dividend distribution policy of a company.
And the second hypothesis is the assumption of having a perfect share market where there is no change in the amount of dividends. Moreover, since there is no change in the internal rate of return, the value earned by shareholders remains the same over time.
Therefore, the shareholders can earn homemade dividends by selling the shares in the markets. By doing so, the shareholders will be left with no loss or no gains. Hence according to MM theory, the valuation of a firm according to dividend policy is faulty and irrelevant.
Arbitrage Cannot Drive the Shareholding and Dividend Patterns
According to the MM model, the internal rate of return should remain the same for all shares in the market. This means that there should be no arbitrage that can be exercised by selling the shares in the markets.
According to the MM model, if there is an arbitrage in dividend yields, the shareholders will buy the higher dividend yielding shares and sell the lower dividend yielding ones. This will continue until there is a uniformity of the arbitrages of shares in the market.
Therefore, according to the MM model of dividend evaluation, the dividend yield of a firm cannot show its true value. So, using dividend yield is ineffective as a tool to measure the valuation of a firm.
The MM model rests on some hypotheses that makes the dividend yielding process irrelevant for the shareholders. Among these hypotheses, the prime ones are −
The assumption of having a perfect share market where the rates of return remain the same,
No taxation on dividends earned, and
Zero risk in investing in the market.
These hypotheses make the MM model an exclusive theory to check the dividend-yield patterns as a measure of a firm's valuation. Unlike Walter’s and Gordon’s models, it is not very rigid, and hence, is applicable to a wide variety of situations.
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