This document summarizes Modigliani & Miller's capital structure theory. It discusses two key aspects of their approach: 1) In the absence of taxes, the capital structure of a company is irrelevant as arbitrage will cause identical firms to have the same market value regardless of debt use. Investors can replicate corporate financing decisions individually. 2) When corporate taxes exist, the value of a company increases with debt as interest payments are tax deductible, lowering the overall cost of capital. The value of a levered firm equals the value of an unlevered firm plus the present value of tax shields provided by debt. 3) An example calculation is provided to illustrate how to determine the value of an unlever

1. Financial Management (KMB 204)
Capital Structure Theory
Modigliani & Miller Approach(PartII)
Prepared by :
Taru Maheshwari
Sr.Asstt.Prof. ABESEC
AKTU (Lucknow)

2. M& M Approach
• A) In absence of Taxes: Theory proves that COC is irrelevant by changes in
Capital structure . If two identical firms in all respects except their capital
structure can not have different MV because of arbitrage process and
investor prefer personal leverage against corporate leverage.
• Implications:
Unlevered Levered
EBIT 200000 200000
7% Deb - 10,00,000
Investor holding 10% equity & Deb
Cost of equity 10% 11.5%

3. Solution (Arbitrage Process)
Unlevered firm Levered Firm
EBIT 200000 200000
Less Int - 70000
EBT 200000 130000
Value of Equity 2000000 1130434
Value of firm 2000000 2130434
Share holding 10%
Investment 20000 213043
profit 13000 13000

4. When Corporate Tax exists
• Value of firm increase and cost of capital decrease
with use of debt on account of deductibility of int for
tax purpose.
• Vu = Profit available to shareholders i.e Ebt (1-tax)/
Equity capitalisation Rate
• Vl = Vu + tD

5. Illustration
Net Operating Income -600000 , Tax -40%, Debt Capital –Rs800000, Interest on Debt 8%, Capitalization Rate for
equity is 12.5% .Calculate Value of firm according to M&M approach.
Solution: Value of Unlevered firm = EBIT(1-tax) /Cost of Equity
= 6000000(1-.40)/12.5%
=Rs2880000
Value of levered firm= Value of unlevered firm+(B*T)
= Rs2880000+(800000*.4)
=Rs3200000.