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

According to the Modigliani and Miller dividend irrelevance proposition, which set of assumptions is required for a company's dividend policy to have no effect on its share value?

Dividend policy is irrelevant when capital markets are perfect, with no taxes, transaction costs or information asymmetry, and when the firm's investment policy is fixed. Value then depends only on the earning power of assets, so investors can create their own cash flows by selling shares.

  1. APerfect capital markets with no taxes or transaction costs, and a fixed investment policyCorrect
  2. BImperfect markets where investors prefer current income to future capital gains
  3. CA tax system that taxes dividends at a lower rate than capital gains
  4. DManagers who hold more information than outside shareholders and use dividends to signal it
  5. Shareholders who face brokerage costs when selling shares to create income

Explanation

M&M show that, with perfect markets (no taxes, no transaction costs, symmetric information) and a given investment policy, value depends on the earning power of assets and not on how earnings are split between dividends and retention. The other options each describe a market imperfection or a preference that would make dividend policy matter.

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