Page 194 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 8: Capital Structure Decision

8.7.4 Modigliani-Miller Approach (MM) Notes

MM theory relating to the relationship between cost of capital and valuation is similar to the
NOI approach. According to this approach, the value of the firm is independent of its capital
structure. However, there is a basic difference between the two. The NOI approach is purely a
definitional term, defining the concept without behavioural justification. MM approach provides
analytically sound, logically consistent, behavioral justification in favour of the theory and
considers any other theories of Capital structure as incorrect.

Assumption

Capital markets are perfect. This means,
1. Investors are free to buy and sell securities.

2. Inventors can borrow and lend money on the same terms on which a firm can borrow and
lend.
3. There are no transaction costs.

4. They behave rationally.
5. Firms can be classified into homogenous risk categories. All the firms within the same
class will have the same degree of business risks.

6. All the investors have the same expectations from a firm's NOI with which to evaluate the
value of the firm.
7. Dividends Payout ratio is 100% and there are no retained earnings.

8. There are no corporate income taxes. This assumption is removed later.

Three Basic Propositions of MM Approach

The overall cost of capital (K ) and the value of the firm (V) are independent of leverage. The K
o o
and V are constant for all the degree of leverage. The total value of the firm is obtained by
capitalizing the EBIT at a discount rate appropriate for its risks class.
1. Cost of equity (K ) is equal to the capitalization rate of a pure equity stream plus a premium
e
for financial risk. The financial risks increases with the leverage and therefore, K increases
e
in a manner to offset exactly the benefit from the use of low cost debt.
K = K + (K - K ) B/S.
e o o d
2. The cut-off rate for investment purposes is completely independent of the way in which an
investment is financed. This is true because cost of capital remains same regardless of the
degree of leverage. So both, investment decision and financing decision are independent.

Notes Proof of MM Argument

The value of a firm depends on its profitability and risks. It is in variant with respect to
relative changes in the firm's capitalization. Similarly, according to the theory, cost of
capital and market value of the firm must be same regardless of the degree of leverage.

The operational justification for the MM hypothesis is the "Arbitrage Argument". The term
arbitrage refers to the act of buying a security in the market, where the price is less and

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