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CA Intermediate · Financial Management and Strategic Management · Dividend Decision

According to the Modigliani-Miller (MM) hypothesis on dividend policy, under which of the following sets of assumptions is the value of a firm unaffected by its dividend decision?

MM's dividend irrelevance holds with perfect capital markets, no taxes or flotation costs, and a given investment policy. Firm value then depends on earning power and investments, not on how earnings are split between dividends and retention. Imperfections such as taxes or information gaps break this result.

  1. APerfect capital markets, no taxes, and a fixed investment policyCorrect
  2. BImperfect capital markets and differential tax rates on dividends and capital gains
  3. CInformational asymmetry between managers and shareholders with floatation costs
  4. DUncertainty with a higher preference for current dividends by investors

Explanation

MM argue that dividend policy is irrelevant when markets are perfect, there are no taxes or transaction costs, and the investment policy of the firm is fixed. Value then depends only on earning power and investment decisions. The other options describe market imperfections, under which dividend policy can matter.

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