Palomino Enterprises has $300 000 in cash. They wish to invest the money in Treasury bonds at 8% and use the returns to pay dividends to shareholders after a year. Alternately, they can pay a dividend and allow shareholders to make the investment. In perfect capital markets, which option will shareholders prefer?

Question

Quizplus · Accepted Answer

In perfect capital markets, shareholders are indifferent between receiving dividends now or later because they can replicate the outcome of the firm's investment decision on their own. This is due to the Modigliani-Miller theorem, which states that in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the firm's financing decisions (including dividend policies) do not affect its value.

Palomino Enterprises Has $300 000 in Cash