Captial Structure MM Theory

1. Theories of Capital Structure
C. Modigliani-Miller Approach
Semester: 5
Sub.: Advance Financial Management
Module 2 (Part 4)
Prepared by: Dr. Sonam Arora

2. Background
M-M Approach was
developed by Prof.
Franco Modigliani and
Prof. Mertan Miller
[MM, hereafter] in
their classic
contribution
on Capital Structure
in 1961.

3. M-M Approach
Assumptions:
1. Information is available to everyone at free of
cost.
2.There is no transaction and bankruptcy cost.
3. Dividend payout ratio is 100 percent.
4. Perfect Capital Market
5. Free market
M-M Approach suggests
that the value of a firm (V)
depends solely on its
future earning stream,
and unaffected by equity
or debt mix (capital
structure decisions).

4. Increase debt
financing results in
increased leverage
If we assume debt
financing resulted in
higher value of firm
than equity
Shareholders of
leveraged firm will
increase their income
by selling the shares
Income from sales of
leveraged firm shares
plus external
borrowings will used
to buy the shares of
unleveraged firm
This practice will
drives the prices of
the stock to the
point where the value
of two firms become
identical.

5. Proposition 1 (Without Tax)
• 100 crore
Equity
• 0 Debt
100 crore
• 80 crore
Equity
• 20 crore
Debt
100 Crore
• 60 crore
Equity
• 40 crore
Debt
100 crore
In zero tax scenario the value of leveraged firm (VL) = the value of unleveraged frim (Vu)

6. Value of firm is independent to its risk class
▪ Under the M-M Approach the total value of
firm is equal to its expected operating
income divided by the discount rate
appropriate to its risk class.

7. Ex.: A firm has a market
value of Rs. 300000 in
form of 50000 equity
shares.The firm is
planning to change its
capital structure by
borrowing Rs. 120000 in
debt and repurchasing
shares. Ignore taxes.
Sol.: Firm total value is Rs. 300000 in form
of equity.This is an unleveraged firm. Here
WACC = ke
Now firm wants to introduce debt capital of
Rs. 120000 by repurchasing of shares.
Share Price: 300000/50000= 6 Rs. Per share
Debt: 120000
No. Of shares reduced while leveraging =
120000/6 = 20000
New Balancesheet is:
30000 Equity shares (6 Rs.) = 180000
Debt = 120000

8. Proposition 2 (Without taxes)
▪ It says that financial leverage is in direct proportion to the cost of equity.
With an increase in the debt component, the equity shareholders
perceive a higher risk to 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
shareholders have the upper hand as far as the claim on earnings is
concerned.Thus, the cost of debt reduces.

9. Thus,
▪ The value of any firm is = PV of future cashflows
V= EBIT-(1-t)/r
▪ As the return is cost for the company so the r is represented by the
WACC
V= EBIT-(1-t)/WACC……………………….1

10. References
▪ G. Sudarsana Reddy, "Financial Management: Principles & Practice" 3rd
Edition. Himalaya Publishing House.
▪ Schall, Lawernce D and Haley CharlesW., Introduction to Financial
Management, McGraw Hill BookCompany, NewYork, London, New Delhi,
Fourth Edition.
▪ Kulkarni, P.V. & Satya Prasad, B.G., “Financial Management – A conceptual
approach”, Himalaya Publishing House, Mumbai.
▪ https://www.youtube.com/watch?v=kJtTe7fhqzI
▪ https://www.youtube.com/watch?v=1cQqgqkbTFI