Question

Modigliani and Miller put forward the idea that the choice of capital structure is irrelevant to the value of the firm

Required:

1. Describe the Modigliani and Miller capital structure theories as fully as possible. Include assumptions made and any key propositions made by Modigliani and Miller.                                

(10 marks)

2. Critically evaluate this theory with regard to its relevance to the real world                                                              

(10 marks)

                                                                                                  (Total 20 marks)

Answer 1

(a): Modigliani and Miller capital structure theory proposes that the market value of a firm is irrelevant to its capital structure. In other words the market value of a levered firm (i.e. a firm using debt) will be equal to market value of an unlevered firm (i.e. a firm with no debt) if both the firms are within the same category of business risk. Hence as per Modigliani and Miller capital structure theory there is no optimal capital structure and so the valuation of a firm is entirely dependent on its operating income.

The main assumptions of the theory are:

• Transaction costs are not present
• Flotation costs are not present
• Stock prices cannot be affected by any of the investors
• All investors have access to all public and private information
• There are no limitations on buying or selling the stock

The key proposition is that V_U = V_L. In other words value of an unlevered firm = value of a levered firm. We can also state that V_U = V_L = EBIT/k_eo

It should be noted that k_eo is the required rate of return on equity of an unlevered firm while EBIT is the earnings before interest and taxes.

Proposition I - A firm’s total market value is independent of its capital structure.

Proposition II – The cost of equity increases with its debt-equity ratio.

Proposition III – A firm’s total market value is independent of its dividend policy.

(b): The Modigliani and Miller capital structure theory holds less relevance in the real world. To start with the theory is based on the assumption that there are no taxes. This is not at all applicable in the real world. Secondly in the real world risk classes are crucial. Also in the real world general equilibrium is the norms while the assumptions of Modigliani and Miller capital structure theory is based on partial equilibrium analysis. Moreover in the real world individuals and firms cannot borrow at the same market rate and bankruptcy is highly prevalent.