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.
ASSUMPTIONS OF MODIGLIANI AND MILLER APPROACH
- There are no taxes.
- Transaction cost for buying and selling securities as well as bankruptcy cost is nil.
- There is symmetry of information. This means that an investor will have access to the same information that a corporation would and investors would behave rationally.
- The cost of borrowing is the same for investors as well as companies.
- There is no floatation cost like underwriting commission, payment to merchant bankers, advertisement expenses, etc.
- There is no corporate dividend tax.
Modigliani and Miller Approach indicates that value of a leveraged firm ( a firm which has a mix of debt and equity) is the same as the value of an unleveraged firm ( a firm which is wholly financed by equity) if the operating profits and future prospects are same. That is, if an investor purchases shares of a leveraged firm, it would cost him the same as buying the shares of an unleveraged firm.