Chartered Financial Analyst Level 2

Explanation

Miller and Modigliani's dividend irrelevance theory states that in a perfect capital market (without taxes, transaction costs, or information asymmetry), investors are indifferent between receiving dividends and capital gains. This is because:

• Dividend irrelevance: The value of a firm is determined by its earning power and investment policy, not by its dividend policy
• Homemade dividends: Investors can create their own dividend policy by selling shares if they want cash, or reinvesting dividends if they want growth
• No preference: In perfect markets, a dollar of dividends is equivalent to a dollar of capital gains

Why other options are incorrect:

• Option B: This contradicts Miller and Modigliani's theory, as they argue investors are indifferent, not that they prefer dividends
• Option C: This relates to tax clientele effects, which Miller and Modigliani did not address in their original theory (they assumed perfect markets without taxes)

Key Insight: Miller and Modigliani's theory is foundational in corporate finance, establishing that dividend policy doesn't affect firm value in perfect capital markets.