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CA Final · Advanced Financial Management · Financial Policy and Corporate Strategy

Which statement best describes the Modigliani-Miller dividend irrelevance proposition in a perfect capital market?

Under MM in a perfect market, firm value is driven by earning power and investment decisions, not by the dividend payout. Investors can create homemade dividends by selling shares or reinvesting, so the split between dividends and retention does not change value.

  1. AFirm value depends on the dividend payout ratio because investors prefer current income
  2. BFirm value is determined by earning power and investment policy, not by how earnings are split between dividends and retained earningsCorrect
  3. CHigher retention always increases share price since the firm can invest at its cost of capital
  4. DDividends signal management confidence, so a higher payout raises value

Explanation

MM argue that in perfect markets with no taxes, no transaction costs and a fixed investment policy, shareholders can create homemade dividends, so payout does not alter value. The first and fourth options reflect the bird-in-hand and signalling views, which MM reject.

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