# Practical Considerations in Dividend Policy & MM Approach
## Practical Considerations When Setting Dividend Policy
### A. Financial Needs of the Company
| Feature | Mature Companies | Growth Companies |
|---|---|---|
| Dividend Payout | High (few new projects) | Low (funds needed for expansion) |
| Market Reaction | Sensitive to dividend changes | Prefer retention; use bonus shares |
| Earnings Usage | Small portion retained | Retain all; gradual dividend increase |
Raising external equity is costly (floatation costs) and dilutes ownership → internal retention preferred when ROI > Ke.
### B. Constraints on Paying Dividends
| Constraint | Explanation |
|---|---|
| Legal | Must comply with Section 123 of Companies Act 2013 |
| Liquidity | Growth companies often lack cash despite showing high accounting profits |
| Capital Market Access | High payout → cash crunch → new equity issuance → ownership dilution |
| Investment Opportunities | Good projects → retain; no viable projects → distribute now, raise funds when needed later |
### C. Payout Policies
| Policy | Description | Best Suited For |
|---|---|---|
| Constant Dividend Policy | Fixed absolute amount paid every year; uses Dividend Equalisation Reserve in poor years | Investors requiring fixed, predictable income |
| Stable Dividend Policy | Fixed payout ratio (%) of net earnings; dividend amount varies with profits | Conservative companies with sustainable profit forecasts |
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## Modigliani-Miller (MM) Approach — Dividend Irrelevance Theory
Core proposition: In a perfect capital market, dividend policy is irrelevant — it does not affect firm value or shareholder wealth.
### Assumptions of MM Approach
| Assumption | Meaning |
|---|---|
| Perfect capital markets | All investors are rational; information freely and equally available |
| No taxes | Dividend income and capital gains taxed identically (i.e., not at all) |
| Fixed investment policy | All investments financed purely through equity; no debt |
| No floatation/transaction costs | No cost to issue new shares or for investors to transact |
| No uncertainty | Investors can perfectly forecast future dividends and prices |
### Three Situations Under MM — Wealth Always Unchanged
| Situation | Mechanism | Net Effect on Shareholder Wealth |
|---|---|---|
| Dividend from Reserves | Cash transfers to shareholders; firm cash reduces | No change in total value |
| Dividend from New Share Issue | Shareholders receive cash; new shareholders dilute existing EPS | Capital loss = dividend received; net wealth unchanged |
| No Dividend (Home-made) | Shareholder sells shares to create own 'income' | Capital loss from sale = foregone dividend; net wealth unchanged |
### Evaluation of MM Approach
Advantages:
- Logically consistent and theoretically rigorous
- Clearly explains dividend irrelevance through the arbitrage/equalisation mechanism
Limitations:
- Assumptions are unrealistic — taxes exist, markets are imperfect, uncertainty is universal
- Fails in real-world conditions where future dividends and earnings are uncertain