MODIGLIANI-MILLER THEORY OF CAPITAL STRUCTURE

This approach states that change in capital structure does not affect the value of the firm. MM approach maintains that the Overall Cost of Capital (K0) remains constant and does not change due to change in debt-equity mix.  It supports NOI approach that market value of a firm is independent of its capital structure. While NOI failed to provide a behavioural justification for its argument; the MM approach provides behavioural justification through the process of arbitrage.

Arbitrage is simultaneously buying and selling securities in two different market in order to earn profit due to differences in prices in those markets. In the same way, MM used two different firms with different market values, where investors switch from one firm to another firm to earn profits due to difference in market value of firms.

Assumptions

  1. Capital markets are perfect: Investors are rational. it means that information is available to all investors easily and freely. Investors are free to buy and sell securities. There is no transaction cost. investors can lend and borrow at the same time.
  2. Dividend Payout Ratio is 100%. It means that retained earnings is 0.
  3. Business risk are equal among all companies with similar operating environment. This means that all companies can be divided into ‘equivalent risk class’ or ‘homogeneous risk class’.
  4. Given the assumption of perfect information and rationality. All investors have same expectations of EBIT from the company.
  5. There are no corporate taxes. (this assumption was removed later)

Prepositions of MM Hypothesis

  1. The Overall Cost of Capital(K0) and the Value of company are independent of capital structure. This means that K0 and V will remain constant at any degree of debt-equity mix.
  2. With increase in debt proportion in the capital structure the financial risk increases due to increase in interest burden. Hence, the equity shareholders also expect higher return. Hence, cost of equity also increases.

SOURCE: FINANCIAL MANAGEMENT BY Dr. SP GUPTA, SAHITYA BHAWAN PUBLICATION