Capital Structure: practice question
Assume capital markets are perfect: no taxes, no transaction costs, and no costs of issuing securities. If Quist Aerospace keeps its investment policy unchanged but cuts its dividend payout ratio from 50% to 20%, the firm's value and its shareholders' wealth will most likely:
- fall because investors prefer higher current dividends
- rise because retained earnings now fund more investment
- remain unchanged
Show answer and explanation
Correct answer: C
Explanation: Under Modigliani and Miller's dividend irrelevance, with investment policy fixed the firm's value depends only on its investments, so dividend policy merely splits returns between cash dividends and share price appreciation. Value does not rise from retaining earnings because investments are unchanged, and it does not fall because shareholders wanting current cash can sell shares in perfect markets.
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