ACCA Financial Management (F9) Certification Practice Exam

According to Irrelevancy Theory, what primarily determines a company's value?

1. Market demand

2. Company's earnings power

3. Dividend payments

4. Shareholder equity

The correct answer is: Company's earnings power

According to Irrelevancy Theory, particularly as articulated by Modigliani and Miller, a company’s value is primarily determined by its earnings power rather than factors such as market demand, dividend payments, or shareholder equity. The theory suggests that in a perfect market, the value of a company is contingent upon its ability to generate future cash flows, which are reflective of its earnings potential. Earnings power refers to the fundamental profitability and operational efficiency of a company. This concept posits that as long as the overall cash flows and the risk profile associated with those cash flows remain unchanged, the company's intrinsic value should remain stable, regardless of its capital structure or dividend policy. Therefore, even if a company were to change its dividend distribution or financing methods, these actions would not affect its overall value as measured by its capacity to generate profits. In this context, the other options, while meaningful in real-world scenarios, do not serve as primary determinants of a company's intrinsic value. Market demand may influence stock price performance but does not fundamentally alter a company's value as calculated by future cash flows. Similarly, while dividend payments can indicate company performance and investor satisfaction, they are not a direct measure of intrinsic value but rather a signal of a company's profitability. Shareholder equity reflects