This lesson examines the seminal Miller-Modigliani (MM) hypothesis, which argues that under perfect market assumptions, dividend policy is irrelevant to firm value. It covers the assumptions, the proof, and the implications of the MM proposition for dividend decisions .

• The MM Irrelevance Proposition: Modigliani and Miller argued that under perfect capital markets, the dividend policy of a firm has no effect on its market value. If the firm’s investment budget is given, dividend policy becomes a financing decision and is irrelevant to shareholder wealth. The value of the firm is determined by its earning power and risk, not by how earnings are distributed .

• The Logic of “Homemade Dividends”: The MM theorem is based on the idea that if investors are dissatisfied with a firm’s dividend policy, they can create their own “homemade” dividends by selling shares to generate income. This makes the firm’s dividend decision irrelevant to the investor. In perfect markets, a firm can pay dividends and cover the shortfall through new share issues without affecting shareholder wealth .

• Key Assumptions of the MM Model: The irrelevance proposition relies on strict assumptions:

  • Perfect capital markets with no transaction costs

  • No taxes (corporate or personal)

  • Rational investors with homogeneous expectations

  • Symmetric information between managers and investors

  • Given investment policy independent of dividend decisions

• Critique of the MM Proposition: The MM proposition has been criticised because its assumptions do not hold in the real world. In the presence of taxes, asymmetric information, and transaction costs, dividend policy can affect firm value .