Question 4 OR (b)
Are the assumptions of the Modigliani-Miller dividend irrelevance hypothesis unrealistic?
5 marks
- Time to write
- About 10 minutes
From an older CBCS paper
Question
Question 4 OR (b) · 5 marks"The assumptions on which the irrelevance hypothesis of Modigliani and Miller is based are unrealistic." Explain.
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
Read from the question
- ExplainTie the answer to the quoted statement: say what it means first, and come back to it at the end.
What the paper leaves open
The paper does not say which Modigliani-Miller irrelevance hypothesis is meant (dividend policy or capital structure). It stands among the dividend questions of Q4 and is read as the dividend irrelevance hypothesis.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 The hypothesis and its argument 1 mark 2 min
- 2 Assumptions set against reality 3 marks 5 min
- 3 Conclusion and limitation 1 mark 1 min
- Check: every ask answered, key terms underlined 1 min
Short on time? Step 2 carries 3 of the 5 marks: guard its minutes.
Try it first. About 10 minutes for 5 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.
As the paper note records, the irrelevance hypothesis is read as the Modigliani-Miller (MM) view on dividend policy.
1The dividend goes out one window, fresh shares are issued at the other—the firm's value stands still.
Paying the dividend is balanced by the new issueShareholders receive cash, but the issue of additional shares lowers the terminal value of their existing shares.
2The old investor counts it out: the share sits lower today by exactly the coins in his hand.
The price falls by the amount of the dividendThe year-end share price falls by exactly the dividend paid
3No dividend declared? He sells a few shares at the counter and makes his own.
Shareholders can make their own dividendsA shareholder who wants cash when no dividend is paid can sell some shares
The hypothesis. MM argue that a firm's dividend policy does not affect the market price of its shares; value is fixed by earning power and investment policy, and the split of earnings between dividends and retention does not matter. Any gain from paying a dividend is cancelled by the fall in share price when outside funds are raised to replace the cash paid out, because the extra shares or funds needed reduce the terminal value of the shares.
Why the assumptions are called unrealistic. The result holds only if certain conditions are met; the test is how close the real world comes to them.
| MM assumption | Reality |
|---|---|
| Perfect capital markets | Perfect markets do not exist in practice |
| Information about the firm is freely available to all | Information does not reach everyone equally |
| No flotation or transaction costs | New issues carry flotation costs, and investors pay brokerage and fees when they deal |
| No taxes, or no difference between the tax on dividends and on capital gains | Taxes exist, and dividends and capital gains are usually treated differently |
| Fixed investment policy of the firm | Firms do not hold their investment plans fixed; they change with opportunities |
| Rational investors who are indifferent between dividends and capital gains | Shareholders may prefer current income to later gains, so dividends matter to them |
| No investor large enough to move the share price | A large holder or institution can influence the price |
Conclusion. Because these conditions do not hold, the hypothesis is a benchmark rather than a description of practice. Its logic is sound and its arbitrage argument is consistent, but the validity of its assumptions is open to question, and it may not hold under uncertainty. Market imperfections therefore leave dividend policy relevant in the real world.
Where the 5 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | The hypothesis and its argument | 1 |
| 2 | Assumptions set against reality | 3 |
| 3 | Conclusion and limitation | 1 |
| Total | 5 |
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