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    SAMIA AKHTAR
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    Modigliani and Miller presented a capital structure theory in 1958 stating that the source of a firm's financing is irrelevant to its value. They assumed perfect markets, no taxes or costs. Later relaxing these assumptions, they found debt provides tax benefits, so firms benefit from more debt. However, their theory was criticized for unrealistic assumptions as capital markets have transaction costs, different borrowing costs, and bankruptcy costs, so a firm's value and WACC do depend on its capital structure.

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    Modigliani and Miller presented a capital structure theory in 1958 stating that the source of a firm's financing is irrelevant to its value. They assumed perfect markets, no taxes or costs. Later relaxing these assumptions, they found debt provides tax benefits, so firms benefit from more debt. However, their theory was criticized for unrealistic assumptions as capital markets have transaction costs, different borrowing costs, and bankruptcy costs, so a firm's value and WACC do depend on its capital structure.

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    374 views2 pages

    Modigliani and Miller Theory

    Uploaded by

    SAMIA AKHTAR
    Modigliani and Miller presented a capital structure theory in 1958 stating that the source of a firm's financing is irrelevant to its value. They assumed perfect markets, no taxes or costs. Later relaxing these assumptions, they found debt provides tax benefits, so firms benefit from more debt. However, their theory was criticized for unrealistic assumptions as capital markets have transaction costs, different borrowing costs, and bankruptcy costs, so a firm's value and WACC do depend on its capital structure.

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    © All Rights Reserved
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    Modigliani & Miller Capital Structure Theory

    In 1958, Modigliani and Miller presented a theory supporting the irrelevance of capital structure
    in firms, when considering the market value of the company and wellbeing of both shareholders
    and debtholders. In their point of view, if markets are efficient the source of financing should not
    be relevant and the way to increase firm value is by earning more and it also depends on the risk
    incurred by the firm.

    M&M World without taxes:


    Their first proposition has the implications that financing and investment decisions are
    independent, internal and external financing are perfect substitutes, equity and debt are also
    perfect substitutes and their optimality is irrelevant as well. The assumptions considered in order
    to present their capital structure theory were the following:

    1. Perfect competition within financial markets


    2. No market frictions regarding supply and demand
    3. No taxes
    4. Inexistence of transaction/bankruptcy/agency costs
    5. No restrictions to financing and debt
    6. Homogeneous expectations
    7. No arbitrage possibilities
    8. Homemade leverage (Portfolios can replicate every debt/equity combination of the firm)

    In their second proposition, Modigliani and Miller conclude that increments in debt/equity ratio
    leads to shareholders also increasing their required return due to the fact that they are incurring in
    higher risk.

    Considering the fact that this proposition does not include taxes and other costs, the weighted
    average cost of capital is constant even if the firm’s capital structure changes since tax benefits
    will cause the weighted average cost of capital to remain constant. Moreover, the irrelevance of
    financing through debt means that the share price is not influenced by the capital structure.

    Although the theory presented by Modigliani and Miller has its flaws, mainly due to unrealistic
    assumptions which are hard to apply in real world situations, by understanding what is not
    important we can also understand what should be important in capital structure. From their
    theorem, we can comprehend that by relaxing an assumption we can then look for the factors that
    do contribute to an optimal capital structure and how they will impact the optimal ratio of
    debt/equity.
    M&M World with taxes:
    When taxes are considered in Modigliani and Miller’s theory, there are changes in their
    propositions which lead to different conclusions.

    In their first proposition, relaxing the assumption of a world without taxes leads to the
    conclusion that there are advantages regarding the use of leverage (debt) which comes from tax
    benefits, i.e., higher amounts of debt lead to higher tax deductions. This means that a firm will
    benefit infinitely by increasing their amount of debt, given that the assumption of inexistent
    bankruptcy costs is not relaxed.

    From their second proposition we can also observe significant changes, even though the fact
    that shareholder’s required return will increase with higher amounts of debt is not relaxed. By
    including taxes, financing through debt becomes cheaper causing the weighted average cost of
    capital to drop and reaching the conclusion that the optimal capital structure is at a level where
    the firm is only financed by debt.

    Criticism

    The Modigliani-Miller theory of capital structure was criticized because the assumption that
    capital markets are perfect is completely unrealistic. The arbitrage, as proof of the Modigliani-
    Miller theory, was also strongly criticized. If there are no perfect capital markets, the arbitrage
    will be useless because a levered and an unlevered firm within the same class of business risk
    will have different market values.

    The reasons why arbitrage does not allow market equilibrium in real life are as follows:

     Transaction costs: If there are transactions costs, buying stock will require bigger initial
    investments, but the return remains the same. Therefore, the market value of a levered
    firm will be higher than an unlevered one, assuming that both of them are within the
    same class of business risk.
     Cost of Borrowing: The cost of borrowing is not the same for individuals and firms. The
    cost of borrowing depends on the individual credit rating of the borrower.
     Institutional Constraints: Institutional investors slow down arbitrage because they limit
    the use of financial leverage by their clients.
     Bankruptcy cost: The higher the financial leverage, the higher is the probability of
    bankruptcy. Therefore, bankruptcy costs have a strong influence on firms.

    Many critics of the Modigliani-Miller theory of capital structure believe that assumptions are
    unrealistic and that the market value of a firm as well as WACC depends on financial leverage.

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