Example: - MM Foam Company at present has 5000 outstanding shares selling at Rs. 100 each. The firm suppose to have a net earning of Rs. 50000 as well as contemplating a dividend of Rs. 6 per share at the end of the current financial year. There is a suggestion for making new investment of Rs. 1, 00,000.

Presumptuous 10% cost of capital show that under MM hypothesis the payment of dividend doesn't affect the value of the firm.

Solution:-

(1) Computation of the value of firm when dividends are paid:-

(i) Cost of the share at end of current financial year:-

P = P_o (1 + K_e) -D1 P = 100 (1+.10) - 6 = Rs. 104 1 1

(ii) Number of shares to be issued:-

  m = I - ( E-nD1)  / P1  =  {1,00,000 - (50,000 - 5,000 x 6) } / 104 = 80,000 / 104

(iii) Value of the firm:-

nP_o = {(n + m) P₁ - I + E} / 1 + K_e

nP_o = { (5,000 + 80,000/104) 104 - 1, 00,000 + 50,000 }/ 1 + .10

nP_o = 6, 00,000 -50,000 / 1.10 = Rs. 5,00,000

(2) Value of the Firm when dividends aren't paid

(i) Cost of the share at the end of current financial year:-

P₁= P_o (1 + K_e) -D₁ P = 100 (1+.10) - 0 = Rs. 110 1

(ii) Number of shares to be issued:-

m = { I - (E-nD1) } / P1 = 1, 00,000 - (50,000 - 5,000 x 0) / 110  = 50,000 / 110

(iii) Value of the firm:-

nP_o = {(n + m) P₁ - I + E} / 1 + K_e

nP_o = {(5,000 + 50,000/110) 110 - 1, 00,000 + 50,000} /  (1 + .10 )

nP_o = 6, 00,000 -50,000 / 1.10 = Rs. 5,00,000

Conclusion: - therefore whether dividends are paid or not the value of the firm remains the same Rs. 5, 00,000