Perfect certainty by every investor as to future investments and profits of the firm. (MM drop this assumption later.)

Dividends versus Terminal Value The aux of MM's position is that the effect of dividend payments on shareholder wealth is offset exactly by other means of financing. Consider first selling additional stock in lieu of retained earrings. When the firm has made its investment decision, it must decide whether to retain earnings or to pay dividends and sell new stock in the amount of these dividends to fiance the investments. MM suggest that the sum of the discounted value per share after financing and dividends paid is equal to the market value per share before the payment of dividends. In other words, the stock's decline in market price because of external financing offsets exactly the payment of the dividend. Thus, the stockholder is said to be indifferent between dividends and the retention of eamings and subsequent capital gains.

The market price of a share of stock at the beginning of a period is defined as equal to the present value of the dividend paid at the end of the period plus the market price at the end of the period. Thus where Po is the market price per share at time 0, p is the capitalization rate for firm in that risk class (this rate is assumed to be constant throughout time), Dl is the dividend per share at time 1, and P, is the market price per share at time