Question

Consider an all-equity-financed firm with perpetual cash flows from assets currently in place of $500 per annum. This firm has 1000 shares outstanding. An investment project is available at time period 1 which will cost $500 and will return 10% per annum in perpetuity. Given that the shareholder's required rate of return is 10% per annum, show the irrelevance of the dividend decision.

Answer 1

The question discusses the irrelevance of the dividend decision in an all-equity-financed firm with a new investment opportunity, applying principles of corporate finance and the Modigliani-Miller theorem.

Step-by-step explanation:

The question posed is about the irrelevance of the dividend decision for an all-equity-financed firm, which is a concept within corporate finance. An investment project with perpetual cash flows represents a fundamental valuation scenario in finance, which can be analyzed using the dividend discount model (DDM). Under the assumptions of the Modigliani-Miller theorem, the market value of an all-equity-financed firm is independent of its dividend policy if the required rate of return on equity remains constant.

In this case, the firm has perpetual cash flows of $500 per annum, 1000 shares outstanding, and a proposed investment project that would return 10% per annum in perpetuity for a cost of $500. With the shareholders' required rate of return also being 10%, we can understand that any cash dividends paid out would not affect the firm's value or the shareholders' wealth, supporting the Modigliani-Miller theorem of dividend irrelevance.