Question

Dividends are value-relevant and we can value firms using the present value of expected future dividends. however, a firm's dividend policy (whether and when it pays dividends) can be irrelevant for valuation under a strong assumption. what is that strong assumption?

a. the assumption of continuing growth after the forecast horizon
b. the assumption that the firm will be able to reinvest capital that is not paid out in dividends, and earn a rate of return equal to the investors' expected rate of return
c. the assumption that the firm always issues and repurchases shares for fair value.
d. the assumption that the firm will be liquidated at some time in the future

Answer 1

The assumption that makes a firm's dividend policy irrelevant for valuation is that the firm will be able to reinvest capital not paid as dividends, earning a return equal to the investors' expected rate of return.

Step-by-step explanation:

The strong assumption that renders a firm's dividend policy irrelevant for valuation is b. the assumption that the firm will be able to reinvest capital that is not paid out in dividends, and earn a rate of return equal to the investors' expected rate of return.

Under this assumption, whether a firm decides to distribute profits as dividends or reinvest them in the business does not affect the value of the firm. This is because the reinvested earnings are presumed to earn a return that the investors expect, which would be the same as if investors received the dividends and invested them at the expected rate of return themselves.

This forms part of the Modigliani-Miller theorem, which states that, in a perfect market the dividend policy of a company is irrelevant as it does not affect the value of the firm. The valuation of a firm ultimately depends on its ability to generate future earnings and not necessarily on the manner in which its earnings are distributed.