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Modigliani & Miller Approach

The document discusses the Modigliani-Miller (M&M) approach, which states that a firm's value is unaffected by its capital structure. It presents two versions - the original 1958 version assumed no taxes, costs, or bankruptcy, while the 1963 version incorporated taxes. The M&M theory shows that with taxes, increasing debt lowers the WACC and raises firm value, with an optimal structure of 99.9% debt. However, the M&M approach makes unrealistic assumptions and ignores costs, so its conclusions have been criticized.

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saidarsika
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462 views11 pages

Modigliani & Miller Approach

The document discusses the Modigliani-Miller (M&M) approach, which states that a firm's value is unaffected by its capital structure. It presents two versions - the original 1958 version assumed no taxes, costs, or bankruptcy, while the 1963 version incorporated taxes. The M&M theory shows that with taxes, increasing debt lowers the WACC and raises firm value, with an optimal structure of 99.9% debt. However, the M&M approach makes unrealistic assumptions and ignores costs, so its conclusions have been criticized.

Uploaded by

saidarsika
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd

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

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