MODIGLIANI AND MILLER MODEL
1 Introduction
All the previous models like Walter a Gordon has
emphasised that dividend declaration non declaration
will necessarily affect the share price
µ
Both these models has dividend in its formula
But MM model to the contrary States that the
dividend policy of the company will not affect the
shareholder's wealth company's wealth
As per MN model it is the investment decision
that decides the wealth of a company
This can be understood through an example as
under
2 The example
The balance sheet of a company is as under
liabilities amount Assets Amount E
Equity 701000 Fixed assets 9,000
Debt O cash 1,000
10,000 10,000
No of shares 1,000 Investment opportunity 71,60
It this company want to takeup an investment project
it has 2 options namely
option 1 option 2
Invest the cash of oh will paidas Declaredin
cash21,000 21,000 will dividend co with cash
for the invst become m will issue new raiseequity
investment shares in Ipo
in fixedassets at ex dividend price
P T O P T O
As per option 1 the As per option 2 the
share price is as under share price is as under
SP before dividend 210 SP before dividend 710
2101000 1,0002 2101000 1,0002
spatter investment will spatter dividend
remain unchanged because com div SP 10
cash becomes an asset and DPS R1
balance sheet wealth will 7100011000
remain unchanged Ex div sp 29
This sp is shared by 11000
sit and wealth become
29,000 1,00084 29184
once dividend is declared I 10,000 worth company will
become 291000 worth company Now the Sp of company
is 29 and at this price the company will make
public issue to make investment of 21,000
No of shares to be issued 111 shares
21000 29
summary of wealth
It div is not It div is
declared declared
say holding
g IÉÉÉt on
Impact on Impact on Impact on
coswealth SH wealth g we SHS wealth
1,00084 210 108h X 210 1,11184 29 She 1084 29 79
2101000 z 2101000 Laing 1084 21 71
wealth 2100
Therefore model tries to explain that if a company
has an investment opportunity it will surely takes it
whether not the dividend is declared
It the company distributes dividend it raises the
required funds through new issue
This will not affect the cos wealth as 27000 goeson
as dividend and come back as capital The same
wealth which is shared by 1000 shares will now be
shared by 1,111shares 9 SP
In this case div decl the SH experiences both joyd
sorrow Joy because he receives dividend and sorrow
because SP drops The dividend benefit is offset by
the capital loss leaving SH wealth unchanged
Super summary
MM model concentrates on dividends irrelevance
on the wealth of CoA SH
2 MM model says that wealth of co sit will remain
unchanged it co has Good investment opportunity
If 3 Bis interpretation
liabilities Amount F Assets Amount E
Equity 701000 Fixed assets 9,000
Debt 0 cash 1,000
10,000 10,000
The balance sheet shown above is not the accountant
balance sheet rather it is Market value balanceshee
A meaning of fixedasset
The term fixed asset used here doesnot mean any
individual fixed asset like Land Building Cor Pam
It is compilation of all projects of a company
whichgenerates revenue
value of asset here represents its fair value not the
historic cost for its book value INDY
Fair value of any asset is present value of its future
CFS discounted at required rate of return
Fixed asset in this example represents investments in
all the projects of the company at its fair value
let us understand difference between accounting Bls
and fair value Bls on assets side
Accounting Bls Fair value B Is
purchase of FA that the
Me
worth 21,000 project of Fas is a
perpetual project PV of
Fixedassets all for 21,000 perpetual Cfs is Cfpa
To cash AK ooo RR
8 ke rake rake
2 1090 ke 8 2 10 0 ke 10707 228 ke lo
c p zi 8 t.hn 24000 8
cigpg zgooox10
10
C1pg 10
I 1,250 21,000 2800
BIS BIS BIS
Fixedassets 1,250 Fixed assets 1,000 FA 2800
From this one can understand that accounting focuses
on costs and FM focuses on fair values
As per mm model when rake ie when company
gives a return exactly as what the SH expects
asset will be fairly valued at cost This situation
is called as Good investment opportunity
If o ke then it is called as best investment
opportunity and it rake then it is called as
sub standard investment opportunity
one should understand that the fair value of all
the assets is called as projects and value of all
projects is value of the business
Therefore value of any business is the presentvalue
of all future cash flows project is expected to
generate discounted at ke
B Meaning of Equity
Here in this modelthe term equity is not Esc
Rest both It is fair value of equity
Though people call share capital as an item of
liability in reality share capital is also an asset
The reason is share value increases it business
perform and share value fall if business doesn't
perform we have already learnt that value of
business is nothing but value of projects and vatu
of projects is nothing but value of all assets and
value of asset is nothing but Pll of all fef so it
company could not generate proper CFC 21223
then value of assets tall eventually value of projes
fall and thereby value of business ball which Wil
then impact the SP Therefore it is clear that Us
is affected by value of business and share doesh
have any separate value on its own
Hence share is an asset of a kind which derives
its value from value of its underlying asset called
Business
so in finance world unlike accountancy there is
no concept of liability Liability is just a
connotation used to settle obligations Hence sp
is just a balancing figure
4 mm theory of irrelevance using formula
I 2 3
single period Amount to be wealth of
holding formula raised in ipolppo company
Po
Dit P IP IPO
It E
It ke I E nD P Ntm
It ke
Po current share price De Dividend after year
P price after l year ke cost of equity
I Investment value a E Earnings
NDE Expected dividend amount ntm total shares
n no of shares before new issue after new issue
m No of shares to be issued
5 Derivation interpretation of formulae
A Po D TP value of share is Pu of Fcf
if he disc ke
like Po Diva'Ger price
yea
1 year
Derivation
ke DI Po
Po
t 9 j g Pi Po
Ke g Di ke
poi Pig
DI Po
Po
Kye Ping
DI PitPo
PO Pokey
Poke P
Pyo
to
D Poke Po P
DI Pocket P
DITP Pocitke
Po DI TPI
It ke
b Amount to be raised from public issue
MP I CE MDD
me no of new shares to be issued
Pr Price of public issue
That means the amount to be raised should be
equal to investment value reduced by net
earnings Net earnings means earnings available
after declaring dividend
c current value of company
Po DI TPI MPI I CE no
ITke
multiply cats and Rats by n
Npo no th P
Itke
Add and deduct mp
Npo no th P MP Mpl
Itke
NPO ND th P I CE MDD mp
It ke
Npo Np NP I E np tmp
it ke
MPO MP TMP ITE
nPo Pi Cnt F ITE
Itke
6 Illustrations from Ism
Example 2
No of Shares 2,001000 Mps 10 DPS 3
ke 10
situational analysis
Dividend is Dividend not
declared declared
PO Po
PI
10
710 731 0
Pi 8 ex dividend P 11 com div
No of shares to be issued since there is no pyt of
to make investment of 61 dividend question of
22100,000 3 75,0008h issuing new shares doesnt
8 arise
Market value 2175,000 8h 8 market value 21001000 21
22100,000 22,001000
1 Given information
Ke 10 No of shares 101000 Mps 2100 DF 2518h
Earnings available 21,001000 Investment 22,001000
step1 calculation of Mps with withoutdividend
Dividend is Dividend not
declared declared
Po Dit P
it ke
II
i the
754 Pl 0 T PI
2100
I O 10 7100
1 0 10
Fios
step2 calculation of no of shares to be raised
Dividend is Dividend not
declared declared
MP I CE ND Ce
no
MX71057 721001000 71,001000 MX71107 22100,000
101000 25 71,001000
7105M 221001000 250,000 2110M 21,001000
2105M 21,501000 M 909 09 Shares
11428 snag
steps calculation of current market value
Dividend is Dividend not
declared declared
Npo P Ntm I E NPO P ChTm ITE
Itke it ke
71051101000 1428.57 21101101000490909
2,001000 11001000 21001000 11001000
1 10 1 10
710100,000 710100,000
value of firm remains the same across any situation
11 Addi illustration1 Given information
Ke 12 No of shares 101000 Mps 2100 DF 21018h
Earnings available 251001000 Investment 210,001000
step1 calculation of Mps with withoutdividend
Dividend is Dividend not
declared declared
Po Dit P
I
it ke i the
0 T PI
2100 7,110121 7100
Pi 7102 p 2112
Step2 calculation of no of shares to be raised
Dividend is Dividend not
declared declared
MP I CE NDP MP I E NDD
71024M 2101001000 2112m 2101001000
75,001000 101000410 751001000 0
2102M 26,001000 7112m 251001000
Me 5882 35 Shares M 44642984ares
Steps calculation of current market value
Dividend is Dividend not
declared declared
Npo P Ntm I E NPO P ChTm ITE
Itke it ke
7102110,000 5882.357 21121101000 446429
210100,000 751001000 I 10,001000 25100100
1 12 1 12
I 2101001000 2101001000
Practical problems Ism
PPL Step1 calculation of Mps with withoutdividend
Dividend is Dividend no
declared declared
Po Dit P PO Di xp
it ke i the
2100 5,11 7100 OTP
PI 7105 p Zll
Steps calculation of no of shares to be issued
I When dividend is declared
MP I E N DD
2105M 25100,008 22150,000 71125,000
2105M 25100,600 71 25,000
2105M F 3175,000
M 3,571 43Shares
I When dividend is not declared
MP CE MDD
I
2110M 25100,000 22,501000
2110M 22,501000
M 2,272 73
Step3 calculation of current my of the firm
I When dividend is declared
NPO P Ntm It E
Itke
105128,571 43 5,001000 2,501000
1 10
230100,000 72150,000
1 10
2251061000
I When dividend is not declared
NPO P Ntm It E
Itke
110 27,272 73 5,001000 2,501000
1 10
E 721501000
1 10
2251061000
PPS step calculation of Mps with withoutdividend
Dividend is Dividend not
declared declared
Po DIT PI POI DI PI
150
P
150
P 2157 PI 165
steps calculation of no of shares to be issued
I when dividend is declared
MP I E MDD
157M 6100,001000 3100,601000 80100,000
157m 6,00 00,000 2,20 00,000
157m 3,801001000
M 2,42 038 22 shares
I When dividend is not declared
MP I CE MDD
165M 6100100,000 3100100,000
1 81,818.18Shares
m
steps calculation of mV of company
In this question we are required to prove that
mu of company is same across any situation
at the END of year
If dividend is paid If dividend is not paid
MY 12 42,038 22 157 MY 11 81,818 18 165
219 5000 519 5008
