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Modigliani and Miller’s Approach

Modigliani and Miller’s Approach

According to MM, under a perfect market condition, the dividend policy of the company is irrelevant and it does not affect the value of the firm. “Under conditions of perfect market, rational investors, absence of tax discrimination between dividend income and capital appreciation, given the firm’s investment policy, its dividend policy may have no influence on the market price of shares”.

Assumptions Of Modigliani and Miller’s Approach:

MM approach is based on the following important assumptions:

1. Perfect capital market.

2. Investors are rational.

3. There are no tax.

4. The firm has fixed investment policy.

5. No risk or uncertainty.

Proof for MM approach

MM approach can be proved with the help of the following formula:

Po = D1 + P1 / 1 + Ke

Where,

Po = Prevailing market price of a share.

Ke = Cost of equity capital.

D1 = Dividend to be received at the end of period one.

P1 = Market price of the share at the end of period one.

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P1 can be calculated with the help of the following formula.

P1 = Po (1+Ke) – D1

The number of new shares to be issued can be determined by the following formula:

M × P1 = I – (X – nD1)

Where,

M = Number of new share to be issued.

P1 = Price at which new issue is to be made.

I = Amount of investment required.

X = Total net profit of the firm during the period.

nD1= Total dividend paid during the period.

Modigliani and Miller’s Approach Modigliani and Miller’s Approach Reviewed by Ikpokolo Francis on Tuesday, June 20, 2017 Rating: 5

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