Modigliani and Miller (MM) argued in 1961 that dividend policy has absolutely no effect on the value of a firm — and this is among the most tested topics in the Dividend Decisions chapter. The core logic: investors don't care whether returns come as dividends or capital gains. When a firm pays more dividends, it raises fresh capital by issuing new shares to fund its projects. The dilution from those new shares exactly cancels the benefit of receiving a dividend. The shareholder's total wealth stays the same. Dividend, in MM's world, is irrelevant.
MM works only under perfect market assumptions — memorise these, as a 2-mark MCQ or short theory question often asks you to list them: (1) no taxes (and no differential tax on dividends vs. capital gains), (2) no transaction or flotation costs, (3) rational investors with identical information, (4) the firm's investment policy is fixed — it does not change based on dividend decisions, and (5) perfectly competitive capital markets. In reality none of these hold perfectly, which is why Walter and Gordon conclude dividend is relevant. But for exam purposes, treat MM's assumptions as given.
The central formula is: P₀ = (D₁ + P₁) / (1 + Kₑ) — where P₀ is today's price, D₁ is the dividend paid at year-end, P₁ is the year-end market price, and Kₑ is the required rate of return on equity. Given P₀ and D₁, you solve for P₁. When the firm pays dividends, it funds the shortfall via fresh equity. The number of new shares to issue (m) is found using: m × P₁ = I − (E − nD₁), where I = total investment required, E = total net earnings, n = existing shares, and nD₁ = total dividend paid. The right-hand side is simply investment minus retained earnings — the funding gap. The arbitrage argument is MM's theoretical backbone: if a company pays no dividend and an investor needs cash, they sell a few shares ("homemade dividend"). If the company pays too much, the investor reinvests. Either way, total wealth is identical. Expect a 4–6 mark question asking you to explain this argument — understand it, don't just memorise it.