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MM Theory

The document summarizes Modigliani and Miller's capital structure theory from 1958. Some key points: 1) They presented a theory that the capital structure of a firm is irrelevant if markets are efficient and there are no taxes or transaction costs. 2) They made unrealistic assumptions like perfect markets, no taxes, no bankruptcy costs. 3) Relaxing the "no taxes" assumption shows debt financing is cheaper due to tax benefits, so firms benefit from more debt. 4) Overall the theory showed what doesn't impact capital structure, helping identify important factors like taxes that do impact the optimal debt to equity ratio.

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Sadia R Chowdhury
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88 views

MM Theory

The document summarizes Modigliani and Miller's capital structure theory from 1958. Some key points: 1) They presented a theory that the capital structure of a firm is irrelevant if markets are efficient and there are no taxes or transaction costs. 2) They made unrealistic assumptions like perfect markets, no taxes, no bankruptcy costs. 3) Relaxing the "no taxes" assumption shows debt financing is cheaper due to tax benefits, so firms benefit from more debt. 4) Overall the theory showed what doesn't impact capital structure, helping identify important factors like taxes that do impact the optimal debt to equity ratio.

Uploaded by

Sadia R Chowdhury
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOC, PDF, TXT or read online on Scribd
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considering the market value of the company and wellbeing

of both shareholders and debtholders, Modigliani and Miller presented a theory supporting the
irrelevance of capital

structure in firms in 1958. If markets are efficient the source of financing should not be relevant and the
way to increase firm value by earning more and it depends on the risk too which is incurred by the firm.

M&M World without taxes

Proposition I has the implications that equity and debt

are perfect substitutes and their optimality is irrelevant as well. Financing and investment decisions are
also

independent, internal and external financing are perfect substitutes.

The assumptions considered in order to present their capital structure theory were the

following:

1- Perfect competition within financial markets

2- No market frictions regarding supply and demand

3- No taxes

4- Inexistence of transaction/bankruptcy/agency costs

5- No restrictions to financing and debt

6- Homogeneous expectations

7- No arbitrage possibilities

8- Homemade leverage (Portfolios can replicate every debt/equity combination

of the firm)

In proposition II, Modigliani and Miller conclude that increments in

debt/equity ratio leads to shareholders also increasing their required return due to the

fact that they are incurring in higher risk.

Considering the fact that this proposition does not include taxes and other costs, the

weighted average cost of capital is constant even if the firm’s capital structure changes

since tax benefits will cause the weighted average cost of capital to remain constant.

Furthermore, the irrelevance of financing through debt means that the share price is not

influenced by the capital structure.

Although the theory presented by Modigliani and Miller has its flaws, mainly due to
unrealistic assumptions which are hard to apply in real world situations, by

understanding what is not important we can also understand what should be important

in capital structure. From their theorem, we can indicate that by relaxing an

assumption we can then look for the factors that do contribute to an optimal capital

structure and how they will impact the optimal ratio of debt/equity.

M&M World with taxes:

When taxes are considered in Modigliani and Miller’s theory, there are changes in their

propositions which lead to different conclusions.

In their first proposition, relaxing the assumption of a world without taxes leads to the

conclusion that there are advantages regarding the use of leverage (debt) which comes

from tax benefits, i.e., higher amounts of debt lead to higher tax deductions. This means

that a firm will benefit infinitely by increasing their amount of debt, given that the

assumption of inexistent bankruptcy costs is not relaxed.

From their second proposition we can also observe significant changes, even though the

fact that shareholder’s required return will increase with higher amounts of debt is not

relaxed. By including taxes, financing through debt becomes cheaper causing the

weighted average cost of capital to drop and reaching the conclusion that the optimal

capital structure is at a level where the firm is only financed by debt.

Conclusion

There are several critisism regarding Modigliani and Miller’s Capital Structure

Theory, by relaxing some of the assumptions, we can study what really impacts

the optimal capital structure of a firm. So, it is important for us to understand what matters and what
does not.

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