MODIGLIANI &

MILLER APPROACH
INTRODUCTION

The M&M Theorem, or the Modigliani-Miller Theorem, was developed by

economists Franco Modigliani and Merton Miller in 1958. The M&M theory
states that the capital market of a company does not affect its overall value of
a firm. M&M approach supports the NOI approach.
Two versions of M&M Theory
 1st version – no tax, no bankruptcy costs, no transaction cost (1958)
 2nd version – with tax, bankruptcy cost, transaction cost (1963)
ASSUMPTIONS
No taxation.
Perfect capital markets exists where investors have the same information,
upon which they react rationally.
No transaction costs.
Debt is risk free.
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.
M&M THEORY – WITHOUT TAXES (1958)
Argument
• As investors are rational, the required return of equity is directly proportional
to the increase in gearing. There is thus a linear relationship between Ke and
gearing (measured as D/E).
• The increase in Ke exactly offsets the benefit of the cheaper debt finance and
therefore the WACC remains unchanged.
Conclusion
• The WACC and therefore the value of the firm are unaffected by changes in
gearing levels and gearing is irrelevant.
The Following Figure Shows The Above Conclusion
PROPOSITION – WITHOUT TAXES

 P1 : The capital structure does not influence the value of a firm (VL = VU).
 P2 : With rise in debt, the equity shareholders perceive a higher risk.
M&M THEORY – WITH TAXES (1963)
Argument
• In 1963, M&M modified their model to reflect the fact that the corporate tax
system gives tax relief on interest payments of debts.
• Since debt interest is tax-deductible, the impact of tax could not be ignored
and perfect capital market assumption still applies here.
• As investors are rational, the required return of equity is directly linked to the
increase in gearing – as gearing increases, Ke increases in direct proportion.
Conclusion
• Gearing up reduces the WACC and increases the MV of the company. The
optimal capital structure is 99.9% gearing.
The Following Figure Shows The Above Conclusion
PROPOSITION – WITH TAXES

• It assumes existence of taxes, therefore, tax benefits due to interest payments

are recognized.
• Cost of debt reduces by interest tax shields.
• Change in debt component can affect value of a firm.
CRITICISMS TO M&M THEORY

• The MM approach assumptions are unrealistic.

• It assumes there are perfect capital markets that don’t exist.
• It ignores the corporate tax and personal taxes that is not practically viable as
shareholders pay taxes on the capital gain.
• This theory assumes there are no floatation and transaction costs which is not
true.
THANK YOU