# Modigliani–Miller (MM) Approach

The MM Approach, proposed by Franco Modigliani and Merton Miller in 1961, is the leading irrelevance theory of dividends.

## Core Hypothesis

MM argue that a firm's dividend policy has no effect on either:

the price of the firm's stock, or
its cost of capital.

According to the MM Hypothesis:

The market value of a firm's equity shares depends solely on its earning power and is not influenced by how earnings are split between dividends and retained earnings.
Market value of equity shares is not affected by dividend size.
There is no meaningful distinction between dividends and share repurchases — both are simply ways to return cash to shareholders.

## Assumptions

Perfect capital markets exist and investors are rational.
No taxes.
All investments are financed through equity only.
No floatation or transaction costs.
Investors can forecast future prices and dividends with certainty.

## The Central Idea

Under these assumptions, if a firm pays a dividend, it must raise an equal amount of new equity to fund its investments. The share price falls by exactly the dividend paid, leaving the shareholder's total wealth unchanged. Hence the dividend decision is irrelevant — value comes from the firm's earning power and investment opportunities, not from how it packages the return of cash.

## Formula (Value of the Firm)

The value of the firm remains unchanged due to the dividend decision. MM uses a valuation formula based on the principle that the current price equals the present value of the next dividend plus the year-end price:

$$P_0 = \frac{D_1 + P_1}{1 + K_e}$$

(where P₁ is the price at the end of year 1) — and the number of new shares to be issued is derived from the firm's financing need after paying dividends.

## Key Takeaway

MM's irrelevance proposition is the theoretical opposite of Walter, Gordon and Lintner: in a perfect, tax-free, frictionless market, what you pay as dividend you lose in capital value — so policy doesn't matter.

Worked example

### Example 1

Intuition of irrelevance: Suppose a share is worth ₹100 and the firm pays a ₹10 dividend. Under MM's assumptions the share price falls to ₹90 (ex-dividend). The shareholder now holds ₹90 of stock + ₹10 cash = ₹100 — exactly the same wealth as before the dividend. This demonstrates why, in a perfect market, the dividend decision does not change shareholder wealth.

⚠️ Common exam mistakes

Listing Walter or Gordon under irrelevance — only the MM Approach argues dividend irrelevance.
Forgetting MM's strict assumptions (no taxes, no transaction/floatation costs, certainty). The irrelevance result depends entirely on these; relaxing them restores relevance.
Believing MM says dividends are worthless — it says dividend policy is irrelevant to value, not that returning cash is pointless.
Overlooking that under MM, dividends and share repurchases are treated as equivalent ways of returning cash.

Reference:

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Modigliani and Miller (MM) Approach

Worked example

⚠️ Common exam mistakes