The document discusses traditional and Modigliani-Miller (MM) approaches to capital structure. The traditional approach argues that a company's value and cost of capital can be optimized through a judicious mix of debt and equity, up to a certain level of debt. Beyond this, increased financial risk from more debt outweighs the benefits of cheaper debt. The MM approach argues that a company's value depends only on its operating income and risk, not its capital structure. It proposes that markets will equalize any differences in value or cost of capital through arbitrage. The cost of equity rises in line with debt, keeping the weighted average cost of capital constant. While influential, the MM approach makes

1. Traditional And MM Approaches In
Capital Structure
- MERIN C

2. Capital Structure
• “Capital Structure of a company refers to the composition or
make up of its capitalization and it includes all long-term
capital resources”.
• It is the mix of a firm’s permanent long-term financing
represented by debt, preferred stock, and common stock
equity.
• Capital structure is the composition of a firm’s financing
consists of equity, preference, and debt.

3. Optimum capital structure
• It is that capital structure at that level of debt – equity
proportion where the market value per share is maximum and
the cost of capital is minimum.
• Optimum capital structure is that combination of debt and
equity that maximises the total value of the firm or minimises
the weighted average cost capital.

4. Objective
• Decision of capital structure aims at the following two
important objectives:
1. Maximize the value of the firm.
2. Minimize the overall cost of capital.

5. Theories Of Capital Structure
Capital Structure Theories
• The important theories are:
Relevant theories Irrelevant theories
Net income approach
Traditional approach
NOI approach
MM approach

6. Assumptions
• There are only two sources of funds used by a firm; debt and
shares.
• The firm pays 100% of its earning as dividend (There are no
retained earnings).
• The firm’s total assets are given and do not change
(Investment decision is assumed to be constant).
• The firm’s total financing remains constant (Total capital is
same, but proportion of debt and equity may be changed).
• The operating profits (EBIT) are not expected to grow.
• The business risk is remained constant and is independent of
capital structure and financial risk.
• The firm has a perpetual life.
• The investors behave rationally.
• There are no corporate or income or personal tax.

7. Traditional Approach
• The NI approach and NOI approach hold extreme views on the
relationship between capital structure, cost of capital and the
value of a firm.
• Also known as intermediate approach, is a compromise
between the net income and net operating approach
• According to this approach, the cost of capital declines and the
value of the firm increases with leverage up to a prudent debt
level and after reaching the optimum point, coverage causes
the cost of capital to increase and the value of the firm to
decline.

8. • According to the traditional approach, value of a firm can be
increased or the cost of capital can be reduced by judicious
mix of debt and equity capital can increase the value of the
firm by reducing overall cost of capital up to certain level of
debt.
• The value of the firm can be increased initially or the cost of
capital can be decreased by using more debt as debt is a
cheaper source than equity. Thus , a optimum capital structure
can be reached by a proper debt equity mix.
• Beyond a particular point the cost of equity increases because
increased debt increases the financial risk of equity
shareholders.
• Thus overall cost of capital decreases up to a certain point,
remains more or less unchanged for moderate increase in debt
thereafter and increases or rises beyond a certain point

9. ke
ko
kd
Debt
Cost

10. • Stage 1: As per Ezra Solomon:
First Stage: The use of debt in capital structure increases
the ‘V’and decreases the ‘Ko’.
• Because ‘Ke’ remains constant or rises slightly with debt,
but it does not rise fast enough to offset the advantages of
low cost debt.
• ‘Kd’ remains constant or rises very negligibly.
• Stage 2: after the firm has reached a certain level of leverage,
increases in leverage have a negligible effect on the value, or
cost of capital. This is so because of increase in cost of equity
due to the added financial risk, just offsets the advantage of
low cost debt WACC will be minimum and the maximum
value of the firm will be obtained
• Stage 3: beyond the acceptable limit of leverage, the value of
firm decreases with leverage or the cost of capital increases
with leverage. This happens because investors perceive a high
degree of financial risk and demand a higher equity
capitalization rate which exceeds the advantage of low cost
debt.

11. Criticism of traditional
approach
• Validity of the traditional view has been questioned on the
grounds that the market value of firm depends upon its net
operating income and risk attached to it.
• Criticised because it implies that totality of risk incurred by all
security holders of a firm can be altered by changing the way
in which this totality of risk is distributed among various
classes of securities.
• Modigilani and Miller criticised the assumption that Ke
remains unaffected by leverage up to some reasonable limit.
They assert that sufficient justification doesn’t exist.

12. Modigilani-Miller Approach
• Abbreviated as MM published their research in 1958 stating that the value
of a firm does not change with the change in the firm’s capital structure
• They have given two approaches
 In the Absence of Corporate Taxes
 When Corporate Taxes Exist
Their hypothesis was made under the assumption of no corporate
taxes and is referred to as MM without taxes
• In 1963 , they corrected their research to show the impact of including
corporate taxes on the firm’s value and is referred as MM with taxes
• It supports the NOI approach which states that capital structure is irrelevant
and Ko is constant
• The basic concept of MM hypothesis is that the value of the firm is
independent of its capital structure and determined solely by its investment
decisions

13. Assumptions
Modigliani and Miller approach is based on the following important
assumptions:
• There is a perfect competitive capital market.
o Investors free to buy and sell securities
o Investors can borrow at same rate as corporations
o Investors are well informed and behave rationally
o No Transaction Costs
• There are no retained earnings.
• The investors act rationally.
• The business consists of the same level of business risk.
• There are no transaction costs.
• The interests rates are equal between borrowing and lending, firms and individuals
• Investors formulate similar expectations about future earnings.
• Firm’s investment schedule and cash flows are assumed to be constant and
perpetual.
• Homogeneous Risk Class: Expected EBIT of all the firms have identical risk
characteristics.
• Risk in terms of expected EBIT should also be identical for determination of market
value of the shares
• Cent-Percent Distribution of earnings to the shareholders
• No Corporate Taxes: But later on in 1969 they removed this assumption.

14. • The MM hypothesis can be explained in terms of their two
propositions.
• MM’s proposition I is that, for firms in the same risk class, the
market value is independent of the debt - equity mix and is
given by capitalizing the expected net operating income by
the capitalization rate appropriate to risk class
• Hence formula for proposition I:
Value of Levered firm = Value of Unlevered firm
Value of firm = NOI/Firm’s cost of capital
• Investment in any kind of firm gives the same result and what
matters is the earnings generated

15. Arbitrage process
• States that two firms with identical assets, Irrespective of how
these assets have been financed cannot command different
market values or have different cost of capital.
• Suppose this was not true and have different market values,
arbitrage or switching will take place to enable investors to
engage in personal leverage.
• Arbitrage is a technical term referring to a situation where two
identical commodities are selling in the same market for
different prices then the market will reach equilibrium when
the dealers start buying at the lower price and sell at the higher
price thereby making profit

16. • Proposition 2:states that the cost of equity is a linear function
of the firm’s debt equity ratio
• the rate of return required by shareholders increases linearly as
the debt/equity ratio is increased i.e the cost of equity rise
exactly in line with any increase in gearing to precisely offset
any benefits conferred by the use of apparently cheap debt.
• The cost of equity in the geared company Kg is the cost of
equity in the ungeared company Ku plus a premium for
financial risk.

17. Criticism
• Lending and borrowing rates discrepancy: the assumption that
investors cannot borrow on the same terms and conditions of a
firm. Because of the substantial holding of fixed assets , firms
have high credit standing, as a results they are able to borrow
at lower rate . If cost of borrowings to an investor is more than
firms borrowing rate, equalization rate will fall short of
completion
• Non substitutability of personal and corporate leverages:
Personal leverage is not substitute for corporate leverage
• Transaction cost: Existence of transaction cost also interface
with the working of arbitrage.
• Institutional restriction on personal leverage also impede the
working of arbitrage.
• Existence of corporate tax

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