According to Modigliani and Miller, what is the relationship between dividend policy and firm value in perfect capital markets?

The correct understanding of the relationship between dividend policy and firm value, as proposed by Modigliani and Miller, is that dividend policy is irrelevant to the value of the firm in perfect capital markets. This foundational theory posits that in an ideal market scenario—where there are no taxes, no transaction costs, and all investors have access to the same information—the way a firm chooses to distribute its profits, whether through dividends or retained earnings, does not affect its overall value.

The reasoning behind this assertion lies in the capital structure and investment decisions of the firm, which are considered to be the primary determinants of value. Since investors can create their own streams of cash flows by buying or selling shares according to their individual preferences for dividends, the decision to pay dividends does not add or subtract value. Therefore, in perfect capital markets, the total cash flows derived from the firm remain constant regardless of how they are distributed.

This principle has significant implications for corporate finance, leading to the conclusion that management should focus on investment decisions that enhance firm value rather than on dividend distribution strategies. Understanding this can help students grasp concepts related to capital structure, financing, and shareholder value in the context of financial theory.