Q. Computation of the Value of the firm?
The argument given by MM in favour of their hypothesis is that whatever increase in the value of the firm results from the payment of dividend will be precisely off set by the decline in the market price of shares because of external financing and there will be no change in the entirety wealth of the shareholders.
For instance if a company having investment opportunities distributes all its earnings among the shareholders, it will have to elevate additional funds from external sources. To be more precise the market price of a share in the beginning of a period is equivalent to the present value of dividends paid at the end of the period plus the market price of the shares at the end of the period.
MM Hypothesis is able to be explaining by following steps:-
Step I: - Computation of the Value of the firm:
Po= (D1 + P1) / (1 + Ke )
Po = Market Price per share at the commencement of the period or prevailing market price of share.
D1 = Dividend to be inward at the end of year 1
P1 = Market cost of shares at the end of year 1
K = Cost of equity capital or else rate of capitalization.
Computation of P1:- The value of P1 is able to be derived by the above equation:
P1 = Po (1 + Ke) -D1
Step II: - Computation of Number of shares to be issued when firm needs additional funds:
m = {I - (E-nD1)} / P1
m = Number of Shares to be issued
I = Total amount needed for investment
E = Earning of the company during the year
nD1 = Total Dividends to be paid.
Step III: - Further calculation of the value of the firm with the help of following formula:
nPo = { ( n + m) P1 - I + E } / (1 + Ke )
m = Number of shares to be issued
E = Total earnings of the company during the period
I = Investment Required
P1 = Market value per share at the end of the period
Ke = Cost of equity
n = number of shares outstanding at the beginning of period
nPo = Value of the firm
D1 = Dividend to be inward at the end of year 1