In CIMA F3, Modigliani and Miller’s (MM) Dividend Irrelevance Theory is a core examinable concept under financial policy decisions. MM argue that dividend policy does not affect shareholder wealth, provided certain highly restrictive assumptions hold true. Under this theory, shareholders are indifferent between dividends and capital gains because they can create their own “homemade dividends” by selling shares if required.
To support this proposition, the following assumptions must apply:
A. There are no transaction costs involved in the issue of new shares (including rights issues)
✔ Correct
CIMA F3 states that MM assume no flotation or transaction costs. If issuing new equity were costly, companies paying high dividends would incur extra costs when raising funds, which would affect shareholder wealth and invalidate dividend irrelevance.
C. Investors act in a rational manner
✔ Correct
The theory assumes investors are rational and base decisions solely on wealth maximisation, not preferences for income versus capital gains. This assumption is explicitly stated in CIMA learning materials.
D. The capital markets are efficient markets
✔ Correct
An efficient market ensures that share prices reflect all available information. CIMA F3 emphasises that efficiency is essential so that financing and dividend decisions do not distort share prices.
Why the other options are incorrect
B. There is a multiplicity of corporate and personal income tax rates
✘ Incorrect
MM’s original theory assumes no taxation, not multiple tax rates. Taxes would make dividends and capital gains unequal.
E. Investors do not always have access to perfect information
✘ Incorrect
MM assume perfect information. Any information asymmetry would affect pricing and invalidate dividend irrelevance.
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