The Modigliani and Miller approach to capital theory, devised in the 1950s, advocates the 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 a lower debt component has no bearing on its market value. Rather, the market value of a firm is solely 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 equity or different combinations of debt and equity. The capital structure of a company can have a majority of the debt component or a majority of equity, or an even mix of both debt and equity. Each approach has its own set of advantages and disadvantages. There are various capital structure theories that attempt 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 the 1950s. The fundamentals of the Modigliani and Miller Approach resemble that of the Net Operating Income Approach. Modigliani and Miller advocate capital structure irrelevancy theory, which suggests that the valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or has a lower debt component in the financing mix has no bearing on the value of a firm.
The Modigliani and Miller Approach further states that the market value of a firm is affected by its operating income, apart from the risk involved in the investment. The theory stated that the value of the firm is not dependent on the choice of capital structure or financing decisions of the firm.
Assumptions of Modigliani and Miller Approach
- There are no taxes.
- Transaction cost for buying and selling securities, as well as the bankruptcy cost, is nil.
- There is a symmetry of information. This means that an investor will have access to the same information that a corporation would and investors will thus behave rationally.
- The cost of borrowing is the same for investors and companies.
- There is no floatation cost, such as an underwriting commission, payment to merchant bankers, advertisement expenses, etc.
- There is no corporate dividend tax.
The Modigliani and Miller Approach indicates that the value of a leveraged firm (a firm that has a mix of debt and equity) is the same as the value of an unleveraged firm (a firm that 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
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.
It says that financial leverage is in direct proportion to the cost of equity. With an increase in the debt component, the equity shareholders perceive a higher risk to 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 the 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 companies. 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. In other words, the actual cost of debt is less than the nominal cost of debt due to 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 the 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 the debt-equity ratio has an effect on the WACC (Weighted Average Cost of Capital). This means that the higher the debt, the lower the WACC. The Modigliani and Miller approach is one of the modern approaches of Capital Structure Theory.