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Week 10 Assignment

Joo Pedro Ribeiro Mariares de Vasconcelos 200806783

Modigliani & Miller Capital Structure Theory

In 1958, Modigliani and Miller presented a theory supporting the irrelevance of capital
structure in firms, when considering the market value of the company and wellbeing
of both shareholders and debtholders. In their point of view, if markets are efficient
the source of financing should not be relevant and the way to increase firm value is by
earning more and it also depends on the risk incurred by the firm.

M&M World without taxes:


Their first proposition has the implications that financing and investment decisions are
independent, internal and external financing are perfect substitutes, equity and debt
are also perfect substitutes and their optimality is irrelevant as well.
The assumptions considered in order to present their capital structure theory were the
following:
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Perfect competition within financial markets


No market frictions regarding supply and demand
No taxes
Inexistence of transaction/bankruptcy/agency costs
No restrictions to financing and debt
Homogeneous expectations
No arbitrage possibilities
Homemade leverage (Portfolios can replicate every debt/equity combination
of the firm)

In their second proposition, Modigliani and Miller conclude that increments in


debt/equity ratio leads to shareholders also increasing their required return due to the
fact that they are incurring in higher risk.
Considering the fact that this proposition does not include taxes and other costs, the
weighted average cost of capital is constant even if the firms capital structure changes
since tax benefits will cause the weighted average cost of capital to remain constant.
Moreover, the irrelevance of financing through debt means that the share price is not
influenced by the capital structure.
Although the theory presented by Modigliani and Miller has its flaws, mainly due to
unrealistic assumptions which are hard to apply in real world situations, by
understanding what is not important we can also understand what should be important

in capital structure. From their theorem, we can comprehend that by relaxing an


assumption we can then look for the factors that do contribute to an optimal capital
structure and how they will impact the optimal ratio of debt/equity.

M&M World with taxes:


When taxes are considered in Modigliani and Millers theory, there are changes in their
propositions which lead to different conclusions.
In their first proposition, relaxing the assumption of a world without taxes leads to the
conclusion that there are advantages regarding the use of leverage (debt) which comes
from tax benefits, i.e., higher amounts of debt lead to higher tax deductions. This means
that a firm will benefit infinitely by increasing their amount of debt, given that the
assumption of inexistent bankruptcy costs is not relaxed.
From their second proposition we can also observe significant changes, even though the
fact that shareholders required return will increase with higher amounts of debt is not
relaxed. By including taxes, financing through debt becomes cheaper causing the
weighted average cost of capital to drop and reaching the conclusion that the optimal
capital structure is at a level where the firm is only financed by debt.

Conclusion:
Even though there are several critics regarding Modigliani and Millers Capital Structure
Theory, it is important for us in order to understand what matters and what does not so
that, afterward, by relaxing some of the assumptions, we can study what really impacts
the optimal capital structure of a firm.

References:
- Corporate Finance (10th Edition) by Stephen Ross & Others
- http://www.efinancemanagement.com/financial-leverage/capital-structuretheory-modigliani-and-miller-mm-approach
- Theoretical Finance course documents