MODIGLIANI AND MILLER APPROACH THEORY OF CAPITAL STRUCTURE

• THEORIES OF CAPITAL STRUCTURE ( M&M HYPOTHESIS)
• FINANCIAL MGMT
• MODIGLIANI AND MILLER APPROACH

1. THEORY OF IRRELEVANCE ( IN THE ABSENCE OF TAXES)
2. THEORY OF RELEVANCE ( IN THE PRESENCE OF TAXES)

• IRRELEVANCE OF CAPITAL STRUCTURE  AND NET OPERATING INCOME APPROACH AND THE MM HYPOTHESIS WITHOUT TAXES

1. DO NOT AGREE WITH THE TRADITIONAL VIEW
2. IN PERFECT CAPITAL MARKET WITHOUT TAXES AND TRANSACTION COSTS, A FIRM’S MARKET VALUES AND THE COST OF CAPITAL REMAIN INVARIANT TO THE CAPITAL STRUCTURE CHANGES
3. THE VALUE OF THE FIRM DEPENDS UPON THE EARNING AND RISK OF ITS ASSETS ( BUSINESS RISK) RATHER THAN THE WAY IN WHICH ASSETS HAVE FINANCE
4. M& M HYPOTHESIS IS IDENTICAL WITH NET OPERATING INCOME APPROACH WHEN TAXES ARE IGNORED. VALUE OF THE FIRM IS THE CAPITALIZED VALUE OF NET OPERATING INCOME
5. BOTH NET OPERATING INCOME AND FIRM’S COST OF CAPITAL ARE ASSUMED TO BE CONSTANT WITH REGARD TO FINANCIAL LEVERAGE
6. COST OF CAPITAL IS NOT AFFECTED BY CHANGES IN THE CAPITAL STRUCTURE.
7. DEBT-EQUITY MIX IS NOT RELEVANT IN THE DETERMINATION OF TOTAL VALUE OF THE FIRM.  AS THE DEBT IS CHEAPER TO EQUITY, WITH INCREASED USE OF DEBT ,RAISES THE COST OF EQUITY. THIS INCREASE IN COST OF EQUITY OFFSETS THE ADVANTAGE OF THE LOW COST OF DEBT
8. THE THEORY EMPHASIZES THE FACT THAT A FIRM’S OPERATING INCOME IS DETERMINANT OF ITS TOTAL VALUE.

• MM HYPOTHESIS
• FOR A LEVERED FIRM

1. THE EXPECTED NET OPERATING INCOME IS THE SUM OF THE INCOME OF THE SHAREHOLDER AND PLUS INCOME OF THE DEBT HOLDER
2. THE LEVERED FIRM’S VALUE IS THE SUM OF THE VALUE OF THE EQUITY AND VALUE OF THE DEBT
3. THE AVERAGE RATE OF RETURN REQUIRED BY ALL SECURITY HOLDERS IN A LEVERED  FIRM IS THE FIRM’S WEIGHTED AVERAGE COST OF CAPITAL

·         UNLEVERED FIRM :-THE ENTIRE NET OPERATING INCOME IS THE SHAREHOLDER NET INCOME

·         UNLEVERED FIRM.S WEIGHTED AVERAGE COST OF CAPITAL = OPPORTUNITY COST OF CAPITAL

• THE COST OF CAPITAL
• 
• ARBITRAGE PROCESS
• ACCORDING TO MODIGLIANI AND MILLER TWO IDENTICAL FIRMS IN ALL RESPECT EXCEPT THEIR CAPITAL STRUCTURES CANNOT HAVE DIFFERENT MARKET VALUE OR COST OF CAPITAL BECAUSE OF ARBITRAGE PROCESS
• SUPPOSE THIS WERE NOT TRUE AND TWO IDENTICAL FIRMS EXCEPT FOR THEIR CAPITAL STRUCTURE HAVE DIFFERENT MARKET VALUE
• ARBITRAGE WILL TAKE PLACE TO ENABLE INVESTORS TO ENGAGE IN THE PERSONAL OR HOMEMADE LEVERAGE AS AGAINST THE CORPORATE LEVERAGE TO RESTORE EQUILIBRIUM
• WHEN INDIVIDUAL BORROW IT IS CALLED PERSONAL OR HOME MADE LEVERAGE
• BORROWING BY THE FIRM IS KNOWN AS CORPORATE LEVERAGE

• ASSUMPTIONS

1. NO CORPORATE TAXES
2. PERFECT MARKET
3. RATIONAL INVESTORS
4. THE EXPECTED EARNINGS OF ALL THE FIRMS HAVE IDENTICAL RISK CHARACTERISTICS
5. THE CUT –OFF POINT OF INVESTMENT IN A FIRM IS THE CAPITALIZATION RATE
6. RISK TO INVESTORS DEPENDS UPON THE RANDOM FLUCTUATIONS OF EXPECTED EARNINGS
7. ALL EARNINGS ARE DISTRIBUTED TO SHAREHOLDERS

• VALUE OF THE FIRM

1. V =EBIT/K
2. V = VALUE OF THE FIRM
3. EBIT = Earning before interest and taxes
4. K= overall cost of capital
5. MARKET VALUE OF EQUITY= V-D=S
6. D =MARKET VALUE OF DEBT
7. COST OF EQUITY =(EBIT –I)/(V-D

• WORKING OF ARBITRAGE PROCESS
• SOLUTION
• 
• THE INVESTOR WILL SELL IN THE MARKET 10% OF SHARES IN COMPANY A FOR 13,000
• ( (10/100)X100000X1.30)=13000
• HE WILL RAISE A LOAN OF 5000 ( (10/100)X50,000)=5000 TO TAKE BENEFIT OF PERSONAL LEVERAGE AS AGAINST THE CORPORATE.
• HE WILL BUY 18,000 SHARES IN COMPANY B WITH THE TOTAL AMOUNT ( 13000+5000). WILL HAVE 12% OF SHARES IN COMPANY B
• GAIN TO INVESTOR BY SWITCHING
• 
• THEORY OF RELEVANCE

1. IN THE ABSENCE OF TAXES,VALUE OF THE FIRM DEPENDS ON THE EXPECTED NET OPERATING INCOME AND THE OPPORTUNITY COST OF CAPITAL ( WHICH IS THE SAME FOR THE LEVERED AND UNLEVERED FIRM) AND THE FIRM’S CAPITAL STRUCTURE DOES NOT AFFECT ITS NET OPERATING INCOME
2. VALUE OF THE FIRM TO REMAIN CONSTANT WITH FINANCIAL LEVERAGE AND OPPORTUNITY COST OF CAPITAL ALSO REMAIN CONSTANT
3. MODIGLIANI AND MILLER RECOGNIZED THE VALUE OF THE FIRM WILL INCREASE OR THE COST OF CAPITAL WILL DECREASE WITH THE USE OD DEBT ON ACCOUNT OF DEDUCTIBILITY OF INTEREST CHARGES FOR TAX PURPOSE.

4. FINANCIAL LEVERAGE DOES NOT AFFECT NET OPERATING INCOME
5. BUT AFFECT SHAREHOLDERS’ RETURN ( EPS AND ROE)

• FINANCIAL LEVERAGE CAUSES TWO OPPOSING EFFECTS

1. INCREASE THE SHAREHOLDER’S RETURN BUT IT ALSO INCREASES THEIR FINANCIAL RISK
2. THE SHAREHOLDER WILL INCREASE THE REQUIRED RATE OF RETURN ( COST OF EQUITY) ON THEIR INVESTMENT TO COMPENSATE FOR THE FINANCIAL RISK
3. THE HIGHER THE FINANCIAL RISK,THE HIGHER’S THE SHAREHOLDER'S REQUIRED RATE OF RETURN
4. THEORY OF RELEVANCE
5. A LEVERED FIRM HAS FINANCIAL RISK WHILE UNLEVERED FIRM IS NOT EXPOSED TO FINANCIAL RISK
6. COST OF EQUITY FOR A LEVERED FIRM SHOULD BE HIGHER THAN OPPORTUNITY COST OF CAPITAL
7. EQUAL TO OPPORTUNITY COST OF CAPITAL PLUS A FINANCIAL RISK PREMIUM
8. LEVERED FIRMS’S OPPORTUNITY COST OF CAPITAL IS THE WEIGHTED AVERAGE OF THE COST OF EQUITY AND COST OF THE DEBT
9. K_e  = k_o +(k_o  -k_d) D/E

10.  COST OF EQUITY IS A LINEAR FUNCTION OF FINANCIAL LEVERAGE

• GRAPH
• 
  

·         MM ASSUME THE LEVERED FIRM’S OPPORTUNITY COST OF CAPITAL TO BE CONSTANT WHILE TRADIONAL VIEW IT DEPENDS UPON FINANCIAL LEVERAGE

• WHEN THE CORPORATE TAXES ARE ASSUMED TO EXIST:- THE HYPOTHESIS IS SIMILAR TO NET INCOME APPROACH. THE OPTIMUM CAPITAL STRUCTURE CAN BE ACHIEVED BY MAXIMIZING THE DEBT MIX IN THE EQUITY OF A FIRM.
• VALUE OF UNLEVERED FIRM (V_U)=(EBIT/K)X(1-T)
• AND THE VALUE OF LEVERED FIRM IS

·         V_L=V_U + TD

• CRITICISM

1. THE ASSUMPTIONS THAT FIRMS AND INDIVIDUAL CAN BORROW AND LEND AT THE SAME DOES NOT HOLD IN PRACTICE
2. INCORRECT TO ASSUME PERSONAL LEVERAGE IS SUBSTITUTE FOR CORPORATE LEVERAGE
3. EXISTENCE OF TRANSACTION COST
4. INSTITUTION RESTRICTION ALSO IMPOSE RESTRICTION
5. EXISTENCE OF CORPORATE TAXES