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Introduction What are the Modigliani-Miller Propositions I and II, and who are M&M?

What sort of impact does this theory have within the business finance sector? Merton Miller and Franco Modigliani turned the finance world on its ear with their theory that dealt with a company's decisive measures to increase capital and cash flow by the use of debt or equity in order to finance its investments would not necessarily matter for the sake of growth. Today that theory is simply known throughout the business finance world as M&M. Capital Structure Capital Structure theory is one of the most puzzling issues in the corporate finance literature. Even after four decades of numerous studies and theories on the subject of capital structure, researchers are still puzzled by their inability to provide a simple and concise answer. Capital Structure refers to the mix of different securities issued by a firm to finance the investments. In a simplified context, it is the proportion of financing from debt and from equity capital. Common ratios such as debt-to-total capital or debt-to-equity quantify this relationship. The capital structure decision centers on the allocation between debt and equity in financing the company. An efficient mixture of capital reduces the price of capital. Lowering the cost of capital increases net economic returns, which, ultimately, increases firm value. Franco Modigliani and Merton Miller sparked interest in capital structure theory. Their continued developments (1963, 1965) and original insights (1978) laid the foundation for modern corporate finance. Another point is how well the theory explained observed facts, such as corporate leverage ratios and market reactions to security issues. Much the financial literature since then has revolved around different theories that try to explain exactly what does matter in determining capital structure. Modigliani-Miller Theorem The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. The theorem contains two propositions (I and II), which is discussed later in the paper. There are other theories and models formulated to assist with the financial decisions and continued study of the market. One of them is the Static Trade-off theory based on the trade-off between advantages and disadvantages of using debt and the attainment of an optimal capital structure. The second of these models is that of the Pecking Order model, which states that corporate debt decisions are driven by the firm's desire to finance investment first internally. Nevertheless, aside from this decision, a firm must manage its capital structure. Imperfections in capital markets, taxes, and other practical factors influence the managing of capital structure. Imperfections may result in a capital structure less than the theoretical optimal (Groth et al, 1997). Essentially, managers should choose the capital structure that they believe would have the highest firm value, which allows the capital structure that maximizes shareholders' interests (Bodie et al, 2002). Proposition I Modigliani and Miller's Proposition I states, "A firm cannot change the total value of its outstanding securities by changing its capital structure proportions." (Harvey, 2004) This proposition is also called the "irrelevance proposition." (Harvey, 2004) The whole idea behind this theorem is that it does not matter where a firm gets its finances from, debt or equity. Allen, Myers, and Brealey called this the "law of conservation of value." (2006, 448) The law of conservation of value is "the value of an asset is preserved regardless of the nature of the claims against it." (Allen, Myers, & Brealey, 2006, 448)

. Proposition II One popular strategy the corporation will use is the equity financing (also known as share capital) that will allow the organization to raise money for company activities by selling common or preferred stock to individual or institutional investors. This Tc implies the tax rate. (Allen. 2006. 1958). this makes the idea that "capital structure is irrelevant even when debt is risky. You still return to the same answer. 449) Many people question the validity of the Modigliani and Miller's proposition. Their proposition "states that with no taxes. meaningless! (Cohen. bankruptcy costs. and with no such benefits. therefore. 2004) The capital structure should not affect the choices made by the investors as long as both parties are using the same risk-free rate of interest. because of the debt for major corporations that is not and never will be risk-free. The formula is derived from the theory of weighted average cost of capital. market. and rates. This rB represents the cost of debt. Under the Proposition II section of the theorem.. transaction costs. which is without tax consideration: Proposition II formula without tax is depicted as: This rS represents the cost of equity This r0 depicts the cost of capital for an all equity firm This rB is the cost of debt This B / S shows the debt-to-equity ratio The Proposition II implies the absences of efficient markets and the borrowing rates for the corporation or individual remains the same. Although most companies are not risk-free in their debt practices. however. which Proposition I and II were formulated to assist with the consideration to taxes. . The formula devised to address the section of the tax implications on the capital structure financing. shareholders receive ownership interests in the corporation. the analysis is focused on the equity/debt ratio of the organization.. This proposition states that the cost of equity is a linear function of the debt to equity ratio for the organization. Proposition I and II have the same assumptions as to absences of taxes. and asymmetry information (Brealey et al. Since the Theorem addresses the impact with and without tax consideration. unless conditions are suffice for management. This r0 shows the cost of capital for an all equity firm. A higher debt-to-equity ratio leads to a higher required return on equity. This B / S is the debt-to-equity ratio. one could only conclude that the whole notion. in absence of taxes..there is no optimal capital structure. and current conditions. 2006. In return for the money paid. Myers. & Brealey. With no optimal capital structure. there are no debt-related tax benefits.of trying to locate the optimal capital structure becomes self-contradictory and thus. because of the higher risk involved for equity-holders in a companies with debt (Miller et al. the outcome from the formula will be irrelevant for the organization. the following formula utilized by Proposition II implicates the tax situation into this theory: Proposition II with Tax is depicted as: This rS depicts the cost of equity. It does not matter how you split the debt or do not split the debt. the MM theorem forms the modern basis of thinking for the capital structure.). Therefore.Modigliani and Miller argue that the debt policy is irrelevant.

) The formula. (Deleted last part of sentence. Conclusion M&M's Proposition I and II rely on a perfect market model. is needed to determine the amount of debt a corporation should accumulate. and individuals and corporations borrow at the same rate. there are other factors. The M&M Theorem implies Proposition I and II that the value of a firm is unaffected by how that firm is financed. . It does not matter what the dividend policy of the organization. Though debt incurred interest is favorable for tax benefits. profitability and market to book value. A more recent study in 1995 by Rajan and Zingales. (Brealey et al. has implications for the difference with the WACC (Miller et al. However. tangible assets. In general. however. It does not matter if the firm's capital is raised by issuing stock or selling debt. Increased risk is incurred. Larger corporations and corporations with high fixed asset ratios tend to have higher debt ratios. M&M brings valuable insight into the use of corporate debt and tax shelters in increasing corporate value. which drives down bond prices and stockholders' rate of return will be expected to increase. the capital structure selection is affected. found the debt ratios of individual companies were dependant on the four factors of size. however. 493) This shows an assessment of risk is the determining factor in the accumulation of debt in financing corporate structures. since the cost of capital is a major factor. which dries up equity. The decision maker will consider all conditions. 2006. and the organization position. Both Proposition I and II give consideration for taxes under the following assumptions that corporations are taxed at the rate TC on earnings after interest. while more equitable firms and higher market to book value firms had lower debt ratios. especially the market. which are not considered when corporate debt is increased. 1958). because the risk to equity rises. economy. as found by Rajan and Zingales. an evaluation of a corporation's standing with the four factors. no transaction cost exist.The cost of equity rises with leverage.