MODIGLIANI AND MILLER CAPITAL STRUCTURE APPROACH

Modigliani and Miller, two professors in the 1950s, studied capitalstructure theory intensely. From their analysis, they developed the
capital-structure
irrelevance
proposition.
Essentially,
they
hypothesized that in perfect markets, it does not matter what capital
structure a company uses to finance its operations. They theorized
that the market value of a firm is determined by its earning power and
by the risk of its underlying assets, and that its value is independent
of the way it chooses to finance its investments or distribute
dividends.
The basic M&M proposition is based on the following key assumptions:

No taxes

No transaction costs

No bankruptcy costs

Equivalence in borrowing costs for both companies and investors

Symmetry of market information,

investors have the same information

No effect of debt on a company's earnings before interest and

taxes

meaning

companies

and

Of course, in the real world, there are taxes, transaction costs,

bankruptcy costs, differences in borrowing costs, information
asymmetries and effects of debt on earnings. To understand how the
M&M proposition works after factoring in corporate taxes, however,
we must first understand the basics of M&M propositions I and II
without
taxes.
Modigliani and Miller's Capital-Structure Irrelevance Proposition
The M&M capital-structure irrelevance proposition assumes no taxes
and no bankruptcy costs. In this simplified view, the weighted average
cost of capital (WACC) should remain constant with changes in the

company's capital structure. For example, no matter how the firm

borrows, there will be no tax benefit from interest payments and thus
no changes or benefits to the WACC. Additionally, since there are no
changes or benefits from increases in debt, the capital structure does
not influence a company's stock price, and the capital structure is
therefore
irrelevant
to
a
company's
stock
price.
However, as we have stated, taxes and bankruptcy costs do
significantly affect a company's stock price. In additional papers,
Modigliani and Miller included both the effect of taxes and bankruptcy
costs.
Modigliani
and
Miller's Tradeoff
Theory
of
Leverage
The tradeoff theory assumes that there are benefits to leverage within
a capital structure up until the optimal capital structure is reached.
The theory recognizes the tax benefit from interest payments - that is,
because interest paid on debt is tax deductible, issuing bonds
effectively reduces a company's tax liability. Paying dividends on
equity, however, does not. Thought of another way, the actual rate of
interest companies pay on the bonds they issue is less than the
nominal rate of interest because of the tax savings. Studies suggest,
however, that most companies have less leverage than this theory
would
suggest
is
optimal.
In comparing the two theories, the main difference between them is
the potential benefit from debt in a capital structure, which comes
from the tax benefit of the interest payments. Since the MM capitalstructure irrelevance theory assumes no taxes, this benefit is not
recognized, unlike the tradeoff theory of leverage, where taxes, and
thus the tax benefit of interest payments, are recognized.
In summary, the MM I theory without corporate taxes says that a
firm's relative proportions of debt and equity don't matter; MM I with
corporate taxes says that the firm with the greater proportion of debt
is
more
valuable
because
of
the
interest
tax
shield.
MM II deals with the WACC. It says that as the proportion of debt in

the company's capital structure increases, its return on equity to

shareholders increases in a linear fashion. The existence of higher
debt levels makes investing in the company more risky, so
shareholders demand a higher risk premium on the company's stock.
However, because the company's capital structure is irrelevant,
changes in the debt-equity ratio do not affect WACC. MM II with
corporate taxes acknowledges the corporate tax savings from the
interest tax deduction and thus concludes that changes in the debtequity ratio do affect WACC. Therefore, a greater proportion of debt
lowers the company's WACC.

Modigliani and Miller Approach indicates that value of a leveraged firm

(firm which has a mix of debt and equity) is the same as the value of
an unleveraged firm (firm which is wholly financed by equity) if the
operating profits and future prospects are same. That is, if an investor
purchases shares of a leveraged firm, it would cost him the same as
buying the shares of an unleveraged firm.
Modigliani and Miller Approach: Two Propositions without Taxes

Proposition 1: With the above assumptions of no taxes, the capital

structure does not influence the valuation of a firm. In other words,
leveraging the company does not increase the market value of the
company. It also suggests that debt holders in the company and equity
share holders have the same priority i.e. earnings are split equally
amongst them.
Proposition 2: It says that financial leverage is in direct proportion to
the cost of equity. With increase in debt component, the equity
shareholders perceive a higher risk to for the company. Hence, in
return, the shareholders expect a higher return, thereby increasing the
cost of equity. A key distinction here is that proposition 2 assumes
that debt share holders have upper-hand as far as claim on earnings is
concerned. Thus, the cost of debt reduces.

Modigliani and Miller Approach: Propositions with Taxes (The

Trade-Off Theory of Leverage)
The Modigliani and Miller Approach assumes that there are no taxes.
But in real world, this is far from truth. Most countries, if not all, tax a
company. This theory recognizes the tax benefits accrued by interest
payments. The interest paid on borrowed funds is tax deductible.
However, the same is not the case with dividends paid on equity. To
put it in other words, the actual cost of debt is less than the nominal
cost of debt because of tax benefits. The trade-off theory advocates
that a company can capitalize its requirements with debts as long as
the cost of distress i.e. the cost of bankruptcy exceeds the value of
tax benefits. Thus, the increased debts, until a given threshold value
will add value to a company.
This approach with corporate taxes does acknowledge tax savings
and thus infers that a change in debt equity ratio has an effect on
WACC (Weighted Average Cost of Capital). This means higher the debt,
lower is the WACC. This Modigilani and Miller approach is one of the
modern approaches of Capital Structure Theory.

Arbitrage process
Arbitrage process is the operational justification for the
Modigliani-Miller hypothesis. Arbitrage is the process of purchasing a
security in a market where the price is low and selling it in a market
where the price is higher. This results in restoration of equilibrium in
the market price of a security asset. This process is a balancing
operation which implies that a security cannot sell at different prices.
The MM hypothesis states that the total value of homogeneous firms
that differ only in leverage will not be different due to the arbitrage
operation. Generally, investors will buy the shares of the firm that's
price is lower and sell the shares of the firm that's price is higher. This
process or this behavior of the investors will have the effect of
increasing the price of the shares that is being purchased and
decreasing the price of the shares that is being sold. This process will

continue till the market prices of these two firms become equal or
identical. Thus the arbitrage process drives the value of two
homogeneous companies to equality that differs only in leverage.

Limitations of MM hypothesis:
1. Investors would find the personal leverage inconvenient.
2. The risk perception of corporate and personal leverage may be
different.
3. Arbitrage process cannot be smooth due the institutional
restrictions.
4. Arbitrage process would also be affected by the transaction
costs.
5. The corporate leverage and personal leverage are not perfect
substitutes.
6. Corporate taxes do exist. However, the assumption of "no taxes"
has been removed later.