Question

Explain M&M Proposition I and M&M
Proposition II

Critically evaluate the relationship between
dividend and firm value in the next A4 page.

Answer 1

M&M proposition I states that in the absence of taxes or costs of financial distress the value of the firm is independent of the percentage of debt or equity in its capital structure. In other words the proposition says that the choice of capital is not relevant for maximizing the value of a firm if there are no taxes and there are no costs of financial distress. In such a case the value of a firm will be determined by its assets only and not by its capital structure.

M&M proposition II states that in the absence of taxes or costs of financial distress the cost of equity capital is increasing in the percentage of debt in the capital structure. In other words the greater the percentage of debt in the capital structure the greater will be the rate of return that will be required by shareholders.

To determine the relationship between dividends and firm value let us first understand the role of dividends. Dividends serve as an indicator of the firm’s performance – both present as well as future – and the potential risk level through lending credibility to management claims. As per the basic dividend theory the market value of a firm is significantly related to its dividends. This is because the market value is nothing but the present value of all dividends that will be paid in future by the firm. Myron Gordon also says that market value of a firm is directly related to its dividend payouts and dividends helps in reducing investor’s uncertainty to a large extent.