Question 3 OR (a) part i

Assumptions of the MM dividend irrelevance theory

3 marks

Time to write
About 6 minutes

From an older CBCS paper

Question

Question 3 OR (a) part i · 3 marks

Write short notes on:

  1. The assumptions of the Theory of Irrelevance of Dividend (MM Approach)

Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.

Before you write

Read off the question and its marks

6 minfor 3 marks

Read from the question

  • short notesA note opens with the meaning, then two or three key points. No long introduction.

Write it in this order

  1. 1 Perfect markets, rational investors, costless information 1 mark 2 min
  2. 2 No flotation or transaction costs; fixed investment policy; no large investor 1 mark 2 min
  3. 3 No taxes or no tax difference; why the assumptions matter 1 mark 2 min

Try it first. About 6 minutes for 3 marks. Write it out, then open the solution.

Solution

Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.

Modigliani and Miller argue that, given the firm's investment policy, its dividend policy does not affect the value of its shares. The hypothesis rests on these assumptions:

  1. Perfect capital markets: investors behave rationally, and information about the company is available to all without cost.
  2. No flotation or transaction costs, so new shares can be issued, and shares sold, at no cost.
  3. A fixed (rigid) investment policy: the firm's investment decision is given and does not change with the dividend decision.
  4. No investor is large enough to affect the market price of the shares.
  5. No taxes, or no difference between the tax rates on dividends and on capital gains.

The ICAI study material states the same assumptions: perfect capital markets with rational investors and freely available information, and no taxes.

Why they matter. Under these assumptions, whatever a shareholder gains from a dividend is exactly offset by the fall in the share price when the firm raises the funds it paid out, so P0 = (D1 + P1) ÷ (1 + ke) and the shareholder's wealth is unchanged. The theory is criticised because these conditions do not hold in reality.

Where the 3 marks sit

#ComponentMarks
1Perfect markets, rational investors, costless information1
2No flotation or transaction costs; fixed investment policy; no large investor1
3No taxes or no tax difference; why the assumptions matter1
Total3
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