This document discusses the Modigliani-Miller capital structure theory, which states that a firm's value and cost of capital are independent of its capital structure under certain assumptions. It provides examples to illustrate the theory, showing that the overall cost of capital remains constant regardless of the debt-to-equity ratio. The document also notes that according to MM, while the cost of debt is lower than the cost of equity, the cost of equity increases in a way that offsets the benefits of using debt.

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2.  Capital Structure decision is relevant to the
valuation of the firm.
 In other words, a change in the financial leverage
will lead to a corresponding change in the overall
cost of capital as well as the total value of the firm.
 If therefore the degree of financial leverage as
measured by the ratio of debt to equity is
increased, the WACC will decline, while the value
of the firm as well as the market price of share will
increase and vice versa.

3.  First there are no taxes.
 Second the cost of debt is less than the cost of
equity.
 Third the use of debt does not change the risk
perception of investor.

4.  A company’s expected annual EBIT is Rs. 50000. The
company has Rs 2,00,000, 10% debenture. The cost of
equity of the company is 12.5%.

5. Net Operating Income (EBIT) Rs 50,000
Less: Interest on debentures (I) 20,000
---------------------------
Earnings available to equity holders (NI) 30,000
Equity Capitalization Rate (ke) 0.125
Market Value of Equity (S) = NI/Ke ----------------------------
2,40,000
Market Value of Debt (B) 2,00,000
Total Value of the firm (S+B) = V ------------------------------
4,40,000
Overall cost of capital = Ke = EBIT/V (%) 11.36
Alternatively: Ko = Ki (B/V) + Ke (S/V)

6.  The essence of this approach is that the capital
structure decision of a firm is irrelevant.
 Any change in leverage will not lead to any
change in the total value of the firm and the
market price of shares as well as the overall
cost of capital is independent of the degree of
leverage.

7.  Overall cost of capital is constant
 Residual value of Equity:
Total market value of equity capital = V - B
 Changes in cost of equity capital:
Ke increases with the degree of leveraging.

8.  A company’s expected annual EBIT is Rs. 50000. The
company has Rs 2,00,000, 10% debenture. The cost of
equity of the company is 12.5%.
 Ke = (EBIT – I)/(V – B)
= Earning available to equity holders/Total
market value of equity shares

9. Net Operating Income (EBIT) Rs. 50,000
Overall capitalisation rate (Ko) 0.125
-----------------------------
Total market value of the firm (V) = EBIT/Ko Rs 4,00,000
Total Value of Debt Rs 2,00,000
Total Market Value of Debt (S) = (V – B) Rs 2,00,000

10.  MM approach support the NOI approach, it
means capital structure and cost of capital is
irrelevant to value of the firm.
 Basic Propositions of the MM approach
-- The overall cost of capital (ko) and the value of
the firm (V) are independent of its capital
structure. The total value is given by capitalizing
the expected stream of operating earnings at a
discount rate appropriate for its risk class.
-- Ke increases in a manner to offset exactly the
use of a less expensive source of funds
represented by debt.

11.  The MM approach illustrates the arbitrage process with
reference to valuation in terms of two firms which are
exactly similar in all respects except leverage so that
one of them has debt in its capital structure while the
other does not.
 To understand the process let us have an example

12.  Assume there are two firms, L and U, which are
identical in all respects except the firm L has 10% Rs
5,00,000 debentures. The EBIT of both the firms are
equal, that is, Rs 1,00,000. The equity capitalization
rate (Ke) of firm L is higher (16%) then that of firm U
(12.5%).
 Solution:

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