Looking for the answer to the question below related to Financial Management?
MM Model argues that dividend is irrelevant as
|A. the value of the firm depends upon earning power
B. the investors buy shares for capital gain
C. dividend is payable after deciding the retained earnings
D. dividend is a small amount
The Correct Answer Is:
- A. the value of the firm depends upon earning power
The MM (Modigliani-Miller) Model, developed by Franco Modigliani and Merton Miller in the 1950s and 1960s, is a fundamental theory in corporate finance that deals with the relationship between a firm’s capital structure (the mix of debt and equity) and its value.
This theory has two propositions, commonly referred to as the Proposition I and Proposition II, both of which are instrumental in understanding why the correct answer to the question is option A: “the value of the firm depends upon earning power.”
Correct Answer (Option A):
The MM Model argues that the value of a firm is primarily determined by its earning power, which is measured by its ability to generate profits. In other words, the Model asserts that the intrinsic value of a company is not significantly influenced by its dividend policy or whether it pays dividends to its shareholders.
Instead, it emphasizes that the market capitalization of a firm is chiefly determined by its expected future cash flows, profitability, and the risk associated with those cash flows.
To explain further, MM Proposition I underlines that in a world with no taxes and no market imperfections (such as transaction costs), the capital structure of a firm is irrelevant to its overall value. This means that the firm’s value would remain the same whether it finances its operations with debt or equity.
The rationale behind this proposition is that investors are primarily concerned with the cash flows they receive from the firm, irrespective of whether these cash flows come in the form of dividends or capital gains (i.e., changes in the stock price).
Therefore, option A is the correct answer because it encapsulates this core idea of the MM Model – that earning power is paramount in determining the value of a firm.
Why the Other Options Are Not Correct:
“Investors buy shares for capital gain” is not the primary reason why the MM Model argues that dividends are irrelevant. While it is true that investors often purchase shares with the expectation of capital appreciation, the Model’s main argument is not centered around investor motivations but rather on the mechanics of how a firm’s value is determined.
“Dividend is payable after deciding the retained earnings” is a statement about the process of dividend distribution rather than a reason for the irrelevance of dividends according to the MM Model.
The Model does acknowledge that dividend decisions are influenced by retained earnings, but it does not consider this as a primary driver of a firm’s value. Instead, it emphasizes that the value of the firm is derived from its ability to generate earnings.
“Dividend is a small amount” is not a valid reason for the irrelevance of dividends according to the MM Model. The Model does not assert that dividends are small or inconsequential; it simply argues that whether a firm pays dividends or retains earnings should not significantly affect its overall value in a world with no market imperfections.
In summary, the MM Model’s primary argument, encapsulated in Proposition I, is that a firm’s value depends primarily on its earning power and the associated cash flows it generates, rather than its dividend policy or capital gains.
This theory provides valuable insights into corporate finance and has had a profound impact on the way businesses think about financing and capital structure decisions, making option A the correct answer.