Modigliani and Miller Approach of CAPITAL STRUCTURE

1. MODIGLIANI AND
MILLER APPROACH

2. Modigliani and Miller developed the two
approaches of capital structure:
1. Modigliani and Miller Approach : Without
Taxes (1958)
2. Modigliani and Miller Approach : With Taxes
(1963)

3. 1. MODIGLIANI AND MILLER THEORY:
WITHOUT TAXES
This approach is an improvement over another approaches. MM
Approach is an identical to NOI Approach
In 1958, Modigliani and Miller published their research stating that the
value of the firm does not change with the change in the firm’s capital
structure. Value of the firm is independent of its capital structure. This
has been proved by operational justifications.
However, their hypothesis was made under the assumption of no
corporate taxes.
The basic concept of this approach is that the value of the firm is
independent of its capital structure and determine solely by its
investment decision.

4. ASSUMPTIONS OF MM APPROACH
1. Investors are Rational
2. Perfect capital market
3. There is zero tax environment
4. There is no transaction cost
5. Earnings are perpetual and constant
6. Dividend payout ratio is 100 percent
7. Investors can borrow without restrictions and can borrow funds
at same rate of interest
8. Investment decisions are known and constant
9. Only two source of finance: debt and equity and debt is less risky
10. There are no cost of financial distress and liquidation
11. The firm can be classified into distinct homogeneous risk classes.

5. Prepositions of MM Approach
Preposition I : Value of Levered Firm is equal to Unlevered
Firm
As per first preposition, vale of the firm following a
particular risk category is equal to its expected operating
income divided by the discount rate appropriate to its risk
class. In simple terms, the firm’s value depends upon
investment decision not on financing decision. Therefore,
total market value of all firms, levered or unlevered firms
having the same business risk remains the same.
Value of levered firm= Value of Unlevered firm

6. • Preposition II : Expected Return on Equity as the
leverage increases
MM proposition II states that with increasing
leverage the cost of equity rises exactly to offset the
advantage of reduced cost of debt to keep the value
of the firm constant. Shareholders expect more and
more return as debt equity ratio increases.
The expected yield on equity capital of levered firm
is equal to the pure equity return plus a premium
for financial risk, which is equal to the spread
between pure equity return and cost of debt in the
proportion of debt equity ratio.
ke= ko+(ko-kd)D/E

7. • Preposition III : Cost of capital of levered firm
is equal to the cost of capital of Unlevered
firm:
The cut off rate for investment purposes is
completely independent of the way in which an
investment is financed.
WACC of Levered firm= WACC Unlevered firm
Cost of capital of levered and unlevered firm will
be equal to the opportunity cost of capital.

8. ARBITAGE PROCESS
• The simple logic of preposition I is that two firms with identical
assets, irrespective of how these assets have been financed, cannot
command different market value. Suppose this were not true and
two identical firms, expect their capital structures, have different
market values.
• In this situation, MM approach provides the operational
justification by employing arbitrage process.
• Arbitrage process is followed to equate the value of levered firm
and unlevered firm.
• The Arbitrage refers to an act of buying a security in one market at
a lower price and selling it to another market at a higher price with
a view to earn profit.
• This process continue till the equilibrium is achieved or comes to an
end when identical firm’s share price is equal.

9. EXAMPLE
Let us assume two firms: ALLEQ and CODEQ. They are identical in every
respect, expect for their capital structures. Firm ALLEQ is an all equity capital
firm and believes in no debt. Firm CODEQ is levered and uses a combination
of debt and equity to acquire the same assets. Both the firms generate same
level of earnings. The financial information of both the companies is given as
follows:
ALLEQ CODEQ
EBIT 5,00,000 5,00,000
Interest @10% - 1,00,000
EBIT 5,00,000 4,00,000
Taxes(no taxes) - -
EAT 5,00,000 4,00,000
Market Value of Debt - 10,00,000
Market Value of equity (equity
capitalization rate, ke= 20%)
25,00,000 20,00,000
VALUE OF FIRM (E+D) 25,00,000 30,00,000
Show arbitrage process assuming you as an investor of CODEQlimited and holds 10
percent outstanding shares of CODEQ Limited.

10. Sale Value +2,00,000
Loan Amount +1,00,000
-Purchase Value -2,50,000
Surplus 50,000
Earnings ( CODEQ
Limited)
Earnings (ALLEQ
Limited)
Earnings +40,000 Earnings +50,000
Interest
on Loan
-10,000
Extra
Earning
+5000
Net
Earnings
40,000 Net
Earnings
45,000

11. CRITICISM OF MM APPROACH
(WITHOUT TAXES)
• It is not possible to borrow funds on the same terms and
conditions as corporate can
• Personal leverage is not substitute for corporate leverage
• Existence of transaction costs
• Institutional Restrictions
• Asymmetric Information
• Existence of corporate tax

12. Modigliani and Miller Approach (With
Taxes)
• In 1963, they corrected their research to show the impact of
including corporate taxes on the firm’s value.
• MM argued that the value of firm will increase and cost of capital
will decline, if corporate taxes are allowed in the exercise. This is
because interest on debt is tax deductible expense, thereby
effective cost of debt is less than the contractual rate of interest.
But a dividend payment to stockholders are not deductible.
Therefore, a levered firm value would be high than the unlevered
firm value.
• MM Stated that the value of levered firm would exceed that of the
unlevered firm by an amount equal to the levered firm’s debt
multiplied by the tax rate.
• VL > VU
• VL – VU = Tax Shield
• Tax Shield = Interest * Tax Rate