Question

Discuss the following issues relating to Modigliani and Miller’s (MM) 1958 capital structure model.
A. What was the importance of the model?
B. What are the basic assumptions of the model?

Answer 1

Answer with Explanation:

Requirement 1:

Modigliani & Miller's theorem helps understanding the value of the company, the factors that results in change in the value of the company and the financial risk that increases the firm's Weighted Average Cost of Capital.

M & M proposition 1:

The M & M proposition 1 (or M & M without Tax model) says that the value of the firm remains the same no matter what is the percentage of debt and equity in the capital structure hence the primary focus of the management must be to decrease cost and increase the return on the investment.

M & M proposition 2:

However later, due to increased critism of not considering the tax implications on the WACC, M & M presented a modified model which is also known as M & M With Tax Model. In it he acknowledges the importance of tax in calculating the WACC and he is of the opinion that the injection of the debt reduces the WACC. Hence the maximum level of debt must be used to exploit all the available investment opportunities.

The value of the company can be calculated using the following formula:

Value of the Company = Free Cash flow * (1 + g)  /  (WACC - g)

The changes in the capital structure results in changes to firm's WACC which changes the value of the company. This clearly shows that if the WACC can be reduced then the value of the firm would increased. Hence M & M model is useful in predicting the Optimal Capital structure that would give lowest WACC and thus highest value of the company.

Requirement 2:

The basic assumptions of M & M proposition without tax Model are as under:

1. There are no transaction costs on trading of securities
2. There are no taxes.
3. The market is perfect market which means that the investor and the corporation have same information which doesn't impacts the decision making of both entities.
4. The Floatation costs are zero which means that their are no issuance costs, listing expenses, etc.
5. The taxes on the Dividend distribution are also zero.

The basic assumptions of M & M proposition with tax Model are as under:

1. There are no transaction costs on trading of securities
2. The capital market is perfect market which means that the investor and the corporation have same information which doesn't impacts the decision making of both entities.
3. The Floatation costs are zero which means that their are no issuance costs, listing expenses, etc.