Modigliani Miller Approach Assumptions And Critical Thinking

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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 debt or equity or different combinations of these two sources. The capital structure of a company can have a majority of debt component or majority of equity, only one of the 2 components or an equal 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 future growth prospect apart from the risk involved in the investment. The theory stated that value of the firm is not dependent on the choice of capital structure or financing decision of the firm. If a company has high growth prospect, its market value is higher and hence its stock prices would be high. If investors do not see attractive growth prospects in a firm, the market value of that firm would not be that great.

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 a symmetry of information. This means that an investor will have access to same information that a corporate would and investors would behave rationally.
  • The cost of borrowing is the same for investors as well as companies.
  • Debt financing does not affect companies EBIT.

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.

Modigliani and Miller Approach: Two Propositions without Taxes

Proposition 1

With the above assumptions of “no taxes”, the capital structure does not influence the valuation of a firm. In other words, leveraging the company does not increase the market value of the company. It also suggests that debt holders in the company and equity shareholders have the same priority i.e. earnings are split equally amongst them.

Proposition 2

It says that financial leverage is in direct proportion to the cost of equity. With an increase in debt component, the equity shareholders perceive a higher risk to for the company. Hence, in return, the shareholders expect a higher return, thereby increasing the cost of equity. A key distinction here is that proposition 2 assumes that debt-shareholders have upper-hand as far as the claim on earnings is concerned. Thus, the cost of debt reduces.

Modigliani and Miller Approach: Propositions with Taxes (The Trade-Off Theory of Leverage)

The Modigliani and Miller Approach assumes that there are no taxes. But in the real world, this is far from the truth. Most countries, if not all, tax a company. This theory recognizes the tax benefits accrued by interest payments. The interest paid on borrowed funds is tax deductible. However, the same is not the case with dividends paid on equity. To put it in other words, the actual cost of debt is less than the nominal cost of debt because of tax benefits. The trade-off theory advocates that a company can capitalize its requirements with debts as long as the cost of distress i.e. the cost of bankruptcy exceeds the value of tax benefits. Thus, the increased debts, until a given threshold value will add value to a company.

This approach with corporate taxes does acknowledge tax savings and thus infers that a change in debt equity ratio has an effect on WACC (Weighted Average Cost of Capital). This means higher the debt, lower is the WACC. This Modigliani and Miller approach is one of the modern approaches of Capital Structure Theory.

Last updated on : February 20th, 2018

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The traditional approach to capital structure suggests that there exist an optimal debt to equity ratio where the overall cost of capital is the minimum and market value of the firm is the maximum. On either side of this point, changes in the financing mix can bring positive change to the value of the firm. Before this point, the marginal cost of debt is less than a cost of equity and after this point vice-versa. 

Capital Structure Theories and its different approaches put forth the relation between the proportion of debt in the financing of a company’s assets, the weighted average cost of capital (WACC) and the market value of the company. While Net Income Approach and Net Operating Income Approach are the two extremes Approach are the two extremes, traditional approach, advocated by Ezta Solomon and Fred Weston is a midway approach also known as “intermediate approach”.

Traditional Approach to Capital Structure:

The traditional approach to capital structure advocates that there is a right combination of equity and debt in the capital structure, at which the market value of a firm is maximum. As per this approach, debt should exist in the capital structure only up to a specific point, beyond which, any increase in leverage would result in the reduction in value of the firm.

It means that there exists an optimum value of debt to equity ratio at which the WACC is the lowest and the market value of the firm is the highest. Once the firm crosses that optimum value of debt to equity ratio, the cost of equity rises to give a detrimental effect to the WACC. Above the threshold, the WACC increases and market value of the firm starts a downward movement.

Assumptions under Traditional Approach: 

  1. The rate of interest on debt remains constant for a certain period and thereafter with an increase in leverage, it increases. 
  2. The expected rate by equity shareholders remains constant or increase gradually. After that, the equity shareholders starts perceiving a financial risk and then from the optimal point and the expected rate increases speedily.
  3. As a result of the activity of rate of interest and expected rate of return, the WACC first decreases and then increases. The lowest point on the curve is optimal capital structure. 

Diagrammatic Representation of Traditional Approach to Capital Structure:

Diagrammatic Representation of Traditional Approach to Capital Structure

Example Explaining Traditional Approach:

Consider a fictitious company with the following data.

ParticularsCase 1Case 2  Case 3Case 4Case 5
Weight  of debt10%30%50%70%90%
Weight  of equity90%70%50%30%10%
Cost of debt10%11%12%14%16%
Cost of equity17%18%19%21%23%
WACC16.3%15.9%
15.5%
16.1%
16.7%

From case 1 to case 3, the company increases its financial leverage and as a result, the debt increases from 10% to 50% and equity decreases from 90% to 50%. The cost of debt and equity also rise as stated in the table above because of the company’s higher exposure to risk. The new WACC is decreased from 16.3% to 15.5%.

As observed, with the increase in the financial leverage of the company, the overall cost of capital reduces, despite the individual increases in the cost of debt and equity respectively. The reason being that debt is a cheaper source of finance.

Now, look at the situation in case 3 to case 5, the company increases its financial leverage further and as a result, the debt is increased from 50% to 90% and equity from 50% to 10%. The cost of debt and equity rise further. The new WACC is increased from 15.5% to 16.7%. As observed, with the increase in the financial leverage of the company, the overall cost of capital increases.

The above exercise shows that increasing the debt reduces WACC, but only to a certain level. After that level is crossed, a further increase in the debt level increases WACC and reduces the market value of the company.

Last updated on : August 31st, 2017

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