The document discusses Modigliani & Miller's capital structure theory. It states that according to their approach from the 1950s, a firm's valuation is irrelevant to its capital structure. Whether a firm is highly leveraged or has low debt, its market value depends solely on operating profits, not capital structure. The document then explains arbitrage as the process that justifies this hypothesis. Arbitrage involves buying securities cheaply and selling them where prices are higher, restoring market equilibrium. This implies that identical securities cannot sell at different prices. Finally, the document outlines the assumptions of M&M's original proposition that capital structure does not affect valuation, and how relaxing those assumptions in proposition two introduces factors like

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

2. Modigliani & Miller approach
The Modigliani and Miller approach to capital theory, devised in the
1950s, advocates the capital structure irrelevancy theory. This suggests
that the valuation of a firm is irrelevant to the capital structure of a
company. Whether a firm is highly leveraged or has a lower debt
component has no bearing on its market value. Rather, the market value
of a firm is solely dependent on the operating profits of the company.

3. • Arbitrage process
Arbitrage process is the operational justification for the Modigliani-
Miller hypothesis. Arbitrage is the process of purchasing a security in a
market where the price is low and selling it in a market where the price
is higher. This results in restoration of equilibrium in the market price of
a security asset. This process is a balancing operation which implies
that a security cannot sell at different prices. The MM hypothesis states
that the total value of homogeneous firms that differ only in leverage
will not be different due to the arbitrage operation

4. Assumptions
• There are no taxes.
• Transaction cost for buying and selling securities, as well as the bankruptcy cost, is nil.
• There is a symmetry of information. This means that an investor will have access to the same
information that a corporation would and investors will thus behave rationally.
• The cost of borrowing is the same for investors and companies.
• There is no floatation cost, such as an underwriting commission, payment to merchant bankers,
advertisement expenses, etc.
• There is no corporate dividend tax.

5. Preposition 1
• With the above assumptions of “no taxes”, the capital structure does
not influence the valuation of a firm. In other words, leveraging the
company does not increase the market value of the company. This is
because 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.

6. Preposition 2 Assumptions
• Assume presence of taxes.
• Transaction cost for buying and selling securities, as well as the
bankruptcy cost, is not nil.
• There is not symmetry of information
• The cost of borrowing is not same for investors and companies.
• There is floatation cost, such as an underwriting commission,
payment to merchant bankers, advertisement expenses, etc.
• There is corporate dividend tax.

7. Preposition2
• Value of firm increase and cost of capital decrease with use of debt on account of deductibility of int for tax
purpose. A levered form should have greater value than unlevered firm. The value of levered firm should be
greater than unlevered firm by an amount equal to levered firm’s debt multiplied by tax rate.