Modiglian and Miller put forward the hypothesis that dividend is a passive variable and it does not influence the share valuation. Thus M-M model is known as Dividend Irrelevance Model. Modigliani and Miller provide the most comprehensive argument for the irrelevance of dividends. They argue that, given the investment decision of the firm, the dividend payout ratio is a mere detail and that it does not affect the wealth of owners. They argue that the value of the firm is determined solely by the earning power of the firm and not its pattern of distribution of earnings that will influence the value of shares.

Assumptions: The basic assumptions of M-M Hypothesis are as follows:

(1) Perfect capital markets exist and investors are rational. Information is available to all free of cost. There is no investor large enough to influence the market price of securities.

(2) There are no transactional costs. It means securities can be bought and sold without paying any brokerage or other expenses.

(3) There are no flotation costs. Capital can be raised without incurring any costs like advertisement, brokerage etc.

(4) No taxes exist or there is no difference in tax rates applicable to dividends and capital gains.

(5) The investment policy of the firm is fixed and does not change. So the financing of investment programme through retained earnings does not change the business risk and there is no change in required rate of return.

(6) There is no uncertainty about the future investments and profits of the firm. So the investors are able to predict future prices and dividends with certainty. (This assumption was later dropped by MM).

The crux of the irrelevance hypothesis is the Arbitrage argument. Arbitrage process as is explained in our chapter on capital structure is the process of entering simultaneously into two transactions which exactly balance each other or completely offset each other. The two transactions are payment of dividend and raising finance for capital investment projections from external sources by issue of new shares or borrowing. If a firm decides to invest some money in a capital project, it has two alternatives (i) either to retain earnings and use it for investment and not to pay dividend or (ii) to pay out dividend and raise exactly the same amount by issue of shares or debentures. This arbitrage process becomes necessary when the firm decides to pay dividend. When the firm pays dividend, it will have to resort to external sources of finance for investment projects. When the shares are issued, the total number of shares increases and the share prices decline. Thus, the shareholders on the one hand .get dividend and on the other hand lose by way of decrease in value of shares. So the investors, according to Modigliani and Miller would be indifferent between dividend and retention of earnings. The investors would not care whether the firms pays dividend or retain the profit. Thus, the dividend decision is irrelevant.

Secondly, irrelevance of dividend will still hold good, whether the finance is raised through issue of shares or by issue of debentures. The investors would be indifferent between debt and equity with respect to leverage. The cost of equity has no relation with leverage and the real cost of debt is the same as the real cost of equity. Cost of capital is also independent of dividend payout ratio.

Thirdly, because of operation of arbitrage, the dividend decision would be irrelevant even under conditions of uncertainty. The market prices of the shares of two firms, with similar business risk, prospective future earnings and investment policies, would be the same, irrespective of their payout ratios. This is because of rational behavior of shareholders. The share value of two firms is not affected by the current or future dividend policies.