Question

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

What are the basic assumptions of the model?

Answer 1

Solution:-

Modigliani & Miller's theorem on capital structure is essentially a take on impact of capital structure on the company's market value. It states that the value of any asset is dependent on its earning power. Therefore, just like any asset, the market value of a company's share is determined by its earning capability and the operating risk of its underlying assets.

There are various types of businesses such as FMCG, Auto, pharma, etc. Some businesses can generate higher returns than others and similarly different businesses have different risks in their underlying assets. Hence, the market values are determined by their earning abilities and underlying risk in their assets.

This means that a change in capital structure has no impact on market value of a firm. A company can have any capital structure (i.e. varying proportions of equity, debt and retained earnings) but its market value would be same under all different structures. Hence, a company financed with 100% equity would have same market value that it would have had it been financed by 100% debt or 50% debt-50% equity. Similarly, whether a company uses retained earnings as part of capital structure or pay out profits in form of dividends doesn't have any impact on market value of firm.

Therefore, the importance of M&M theory lies in its emphasis on the role that earnings and operating risk play in valuation of securities and the thesis that the valuation is independent of capital structures.

The basic assumptions under the model are as follows:

• No transaction costs on trade of securities
• No taxes
• Information is perfectly available which helps investors take right decisions
• Zero floatation costs such as listing expenses, underwriter fee, etc
• Dividend distribution tax is zero