Modigliani and Miller

Topics: Finance, Modigliani-Miller theorem, Stock Pages: 6 (2017 words) Published: March 13, 2011
For a firm, the most significant everlasting theme is getting the maximum profit is by minimising cost and taking the least risk. Capital Structure refers to the mix of sources from where the long term funds required in a business may be raised, i.e., what should be the proportions of equity share capital, preference share capital, internal sources, debentures, and other sources of funds in the total amount of capital which an undertaking may raise for establishing its business. A bad financing decision may result in many forms of higher direct or indirect costs, such as lowering stock price, higher cost of capital and lost growth opportunities, increased probability of bankruptcy, higher agency cost and possible wealth transfers from one group of investors to another. Therefore how a manager finances a firm becomes a key concept to a firm. The founderstone of this theory is the Modigliani –Miller theory (MM). MM was developed by two economists, Franco Modigliani, a professor at Massachusetts Institute of Technology, and Merton Miller, a professor at University of Chicago Graduate School of Business. By this main contribution, Modigliani won the Nobel Prize in Economics in 1985 and Miller won the Nobel Prize in Economics in 1990.

MM postulate in his interview that “we should not try to make our shareholders wealthy by adjusting debt levels, because at least in the somewhat idealized world in which economists operate, and sometimes in practice it will not work. Instead, MM further argues, the company's best capital structure is one that supports the operations and investments of the business. The concept of Modigliani-Miller Theorem holds that a fim’s market value is calculated by the risk associated with the underlying assets of the firm and also on the earnings capacity of the firm. This theory is based on some assumptions that there is a control aspects of shares which are ignored, there are no taxes and that there exist a perfect market where shareholders can lend and borrrow at the same interest rate and there is no bankruptcy . However the MM theory also gives us a second proposition whereby there is the existence of tax, this proposition states that a levered firm expected returns will be given by a linear function of the ratio of debt and equity. He also postulates that all investors have the same expectations from a firm’s net operating income (EBIT) which are necessary to evaluate the value of a firm and the divident payment ratio is 100%. In other words, there are no retaines earnings. MM agree that while companies in different industries face different risks which will result in their earnings being capitalized at different rates, it is not possible for these companies to affect their market values, and therefore their overall capitalization rate by use of leverage. That is for a company in a particular risk class, the total market value must be same irrespective of porportion of debt in company’s capital structure. The supprt for this hypothesis lies in the presence of arbitrage in the capital market. They contend arbitrage will substitute personal leverage for corporate leverage. This can be illustrated in the example : Suppose there are two companies X & Y in the same risk class. Company X is financed by equity and company Y has a capital structure which includes debt. If market price of share of company Y is higher than company X, market participants would take advantage of difference by selling equity shares of company Y, borrowing money to equate their personal leverage to the degree of corporate leverage in company Y, and use these funds to invest in company X. The sale of Company Y share will bring down its price until the market value of company Y debt and equity equals the market value of the company financed only by equity capital.

However these assumptions have been criticized by numerous authorities. Mostly criticism...
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