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Modigliani and miller approach

Modigliani and Miller initially developed their capital structure approach in 1958 without considering taxes. They argued that a firm's value and cost of capital are independent of its capital structure. In 1963, they revised their approach to include taxes. When taxes are considered, firm value increases with leverage as interest expenses are tax deductible, creating a tax shield. The value of a levered firm exceeds an unlevered firm by the amount of debt multiplied by the tax rate.

Economy & Finance◦
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MODIGLIANI AND MILLER APPROACH
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)
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.
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.
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
• 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
• 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.
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.
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.
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
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
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