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IAI Actuarial Core Principles · Business Finance · Capital structure and dividend policy

According to the Modigliani and Miller dividend irrelevance proposition, under perfect capital markets with no taxes or transaction costs and a fixed investment policy, which statement is correct?

Under Modigliani and Miller's assumptions, firm value depends on investment decisions and earning power, not on the dividend payout split, because shareholders can replicate any preferred cash flow pattern by buying or selling shares themselves.

  1. AA company's value is determined by its investment decisions, not by how earnings are split between dividends and retained profitsCorrect
  2. BA higher payout ratio always raises the share price because dividends are less risky than capital gains
  3. CA lower payout ratio always raises share price because retained profits are a cheaper source of finance
  4. DShare value is maximised when the company pays out exactly 50% of its earnings
  5. Dividend policy changes the cost of equity because investors prefer cash in hand

Explanation

With perfect markets, investors can create any desired cash flow by selling shares or reinvesting dividends (homemade dividends). Value therefore depends on the earning power of assets and investment policy. The other options describe the bird-in-the-hand view or unsupported rules.

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