Question

In the M&M ideal world, what payout policy should a company follow?

		Pay out all residual cash flows after investing in all positive NPV projects
		Never pay a dividend because shareholders do not care
		Do not buy back stocks because of potential dilution
		Maintain a stable dividend

Answer 1

Ans: b) Never pay a dividend because shareholders do not care.

Explanation:

According to Modigliani and Miller’s Dividend Irrelevance Theory- in an ideal world (Perfect Market Condition) i.e. with no taxes, no floatation cost, no bankruptcy cost, no transaction cost, the dividend policy is irrelevant. MM projected that the dividend strategy of a firm has no impact on its capital structure and the stock’s price. They proposed that if a company pays dividend to its shareholder which is higher than the amount of his expectation then he can re-invest in the firm’s stock with the extra cash flow. On the other hand, if the amount of the expected dividend is very low then the shareholder can sell a portion of his stocks and reproduce the same cash flow. In both the situations, shareholders are irrelevant to the dividend policy of the company because they can make their own cash flows by reinvesting and selling of stocks. According to MM, shareholder only cares about higher returns whether it is from reinvesting or selling of shares. In perfect market conditions mentioned above, shareholders don’t care about the sources of return i.e. whether the return comes from share’s dividend or from the appreciation in stock prices.

From the above discussion it is clear that “In the M&M ideal world, company should follow never pay a dividend payout policy because shareholders do not care about the sources of return.

So, our Answer option is b) Never pay a dividend because shareholders do not care.

Ans: b) Never pay a dividend because shareholders do not care.