## Modigliani-Miller (MM) Approach

MM proposed in 1961 that dividend policy is irrelevant to firm value under perfect market conditions. The value of a firm is determined solely by its earning power and investment decisions, not by how profits are split between dividends and retention.

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### Assumptions of MM Approach

#	Assumption	Meaning
1	Perfect Capital Markets	All investors rational; information freely available to all
2	No Taxes	No difference in taxation of dividends vs. capital gains
3	Fixed Investment Policy	All investments financed through equity only; no debt
4	No Floatation/Transaction Costs	No cost to issue new shares or transact
5	No Uncertainty	Investors can accurately forecast future dividends and prices

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### Three Situations Under MM Approach

#### Situation 1: Dividend Paid from Reserve & Surplus

> Cash moves from firm to shareholders → firm's cash decreases but total value is unchanged.

#### Situation 2: Dividend Paid by Issuing New Shares

> Shareholders receive cash dividend but suffer a capital loss due to EPS dilution from new shares. The two effects cancel out → total wealth unchanged.

#### Situation 3: No Dividend Paid

> Shareholders can create their own dividend by selling a portion of shares (Home-made Dividend). They receive cash but suffer capital loss from reduced shareholding. Net wealth unchanged.

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### The Arbitrage Argument (Core Logic)

MM argues that whatever the firm gains by retaining earnings (reinvestment) is exactly offset by the loss to shareholders (lower dividend today). Rational investors can replicate any dividend policy through personal transactions—so the firm's payout policy is irrelevant.

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### Advantages of MM Approach

Logically consistent and theoretically sound.
Clearly explains dividend irrelevance using the arbitrage process.

### Limitations of MM Approach

Limitation	Detail
Unrealistic assumptions	No taxes and perfect markets do not exist in reality
Ignores uncertainty	Real-world investors cannot accurately predict future dividends/prices

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> Exam tip: MM's irrelevance applies only under perfect market conditions. All relevance theories (Walter, Gordon, Lintner) relax one or more of these assumptions to show dividends do matter in the real world.

Worked example

### Example 1

XY Ltd. earns ₹10/share. Scenario A: Pays ₹5 dividend. Share price before dividend = ₹100; after dividend = ₹95 (drops by dividend amount). Shareholder wealth: ₹5 cash + ₹95 share = ₹100. Scenario B: No dividend. Share price stays ₹100. Shareholder sells 0.05 shares (home-made dividend) = ₹5 cash; retains 0.95 shares = ₹95. Total = ₹100. Under MM, wealth is identical in both scenarios—dividend policy is irrelevant.

### Example 2

MM vs. Reality: In India, dividend income above ₹5,000 from a domestic company is subject to TDS. Capital gains on shares are taxed at 12.5% LTCG or 20% STCG. This tax asymmetry directly violates MM's 'no tax' assumption, making dividend policy relevant in practice. High-tax investors prefer buybacks; income-seeking investors prefer cash dividends.

⚠️ Common exam mistakes

Confusing MM (irrelevance) with Walter/Gordon (relevance)—MM says dividends don't matter; Walter and Gordon say they do, and for opposite reasons depending on r vs. Ke.
Thinking MM approach supports paying zero dividend—it says the level of dividend doesn't affect value; it does not prescribe any specific payout level.
Applying MM's conclusion to real-world decisions without noting its assumptions are violated—taxes, imperfect information, and transaction costs all exist.
Confusing home-made dividend (selling shares to create cash) with actual dividends—both create equivalent wealth only under MM's perfect market assumptions.

Reference:

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Modigliani-Miller (MM) Approach — Dividend Irrelevance Theory

Worked example

⚠️ Common exam mistakes