Modigliani and Miller approach to capital theory, devised in the 1950s advocates capital structure irrelevancy theory. This suggests that the valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or has lower debt component, it has no bearing on its market value. Rather, the market value of a firm is dependent on the operating profits of the company.
The capital structure of a company is the way a company finances its assets. A company can finance its operations by either equity or different combinations of debt and equity. The capital structure of a company can have a majority of the debt component or a majority of equity or a mix of both debt and equity. Each approach has its own set of advantages and disadvantages. There are various capital structure theories, trying to establish a relationship between the financial leverage of a company (the proportion of debt in the company’s capital structure) with its market value. One such approach is the Modigliani and Miller Approach.
MODIGLIANI AND MILLER APPROACH
This approach was devised by Modigliani and Miller during 1950s. The fundamentals of Modigliani and Miller Approach resemble that of Net Operating Income Approach. Modigliani and Miller advocate capital structure irrelevancy theory. This suggests that the valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or has lower debt component in the financing mix, it has no bearing on the value of a firm.
Modigliani and Miller Approach further states that the market value of a firm is affected by its operating income apart from the risk involved in the investment. The theory stated that the value of the firm is not dependent on the choice of capital structure or financing decision of the firm.
They advocated that the weighted average cost of capital does not make any change with a proportionate change in debt-equity mix in the total capital structure of the firm.
The same can be shown with the help of the following diagram
The following propositions outline the MM argument about the relationship between cost of capital, capital structure and the total value of the firm:
(i) The cost of capital and the total market value of the firm are independent of its capital structure. The cost of capital is equal to the capitalisation rate of equity stream of operating earnings for its class, and the market is determined by capitalizing its expected return at an appropriate rate of discount for its risk class.
(ii) The second proposition includes that the expected yield on a share is equal to the appropriate capitalization rate of a pure equity stream for that class, together with a premium for financial risk equal to the difference between the pure-equity capitalization rate (Ke) and yield on debt (Kd). In short, increased Ke is offset exactly by the use of cheaper debt.
(iii) The cut-off point for investment is always the capitalization rate which is completely independent and unaffected by the securities that are invested.
The MM proposition is based on the following assumptions
(a) Existence of Perfect Capital Market It includes:
(i) There is no transaction cost;
(ii) Flotation costs are neglected;
(iii) No investor can affect the market price of shares;
(iv) Information is available to all without cost;
(v) Investors are free to purchase and sale securities.
(b) Homogeneous Risk Class/Equivalent Risk Class: It means that the expected yield/return have the identical risk factor i.e., business risk is equal among all firms having equivalent operational condition.
(c) Homogeneous Expectation: All the investors should have identical estimate about the future rate of earnings of each firm.
(d) The Dividend pay-out Ratio is 100%: It means that the firm must distribute all its earnings in the form of dividend among the shareholders/investors, and
(e) Taxes do not exist: That is, there will be no corporate tax effect (although this was removed at a subsequent date).
Interpretation of MM Hypothesis
The MM Hypothesis reveals that if more debt is included in the capital structure of a firm, the same will not increase its value as the benefits of cheaper debt capital are exactly set-off by the corresponding increase in the cost of equity, although debt capital is less expensive than the equity capital. So, according to MM, the total value of a firm is absolutely unaffected by the capital structure (debt-equity mix) when corporate tax is ignored.