Explain about Modigliani – miller theory of capital structure.

Company finances its assets by capital structure. It can finance its assets by either only equity or combination of debt and equity.

Modigliani and miller proposed a theory in 1950s, which says, valuation of a company is irrelevant to its capital structure. It is also irrelevant, to whether company is highly leveraged or low debt because of its market value. It depends only on operating profits of company. This theory is also called as capital structure irrelevance principle.

Modigliani and miller approach states the valuation of company is irrelevant to its capital structure. Let us say, Company X is financed by equity only (unlevered) and company Y is financed by combination of equity and debt (levered).

According to Modigliani and miller approach value of both company’s X and Y are same. Value of company is independent of its capital structure/financing decisions.

Assumptions of Modigliani and miller theory are as follows −

• No taxes.

• Transaction cost equals to zero.

• Floatation cost equals to zero.

• Symmetrical information (same information is accessed by both investors and corporates).

• No corporate dividend tax.

Proposition without taxes

Market value doesn’t affect the value of company. That means, leverage of company has no effect on its value. Both equity shareholders and debt shareholders will be given same priority.

𝑉𝐿 = 𝑉�

Financial leverage has direct proportion to cost of equity. That means, if debt component increases, equity shareholders perceive high risk. In this proposition, debt holders have upper hand in claiming.

$$R_{E} = R_{O}+ \left(\frac{D}{E}\right)(R_{O}-R_{D})$$

Propositions with taxes

In this, corporate taxes and its benefits are considered (as in real world will have taxes). Change in debtequity ratio has an effect on weighted average cost of capital (WACC). Higher the debt, lower the WACC.

1) 𝑉𝐿 = 𝑉𝑈 + 𝑡𝑐𝐷
2) 𝑅𝐸 = 𝑅𝑂 + (
𝐷
𝐸
) (1 − 𝑡𝑐)(𝑅𝑂 − 𝑅𝐷)
Modigliani and miller approach and WACC =>𝐸𝑊𝐴𝐶𝐶 = (
𝐸
𝑉𝐿
) 𝑅𝐸 + (
𝐷
𝑉𝐿
) 𝑅𝐷(1 − 𝑡𝑐)

Where, 𝑉𝐿= levered firms, 𝑉𝑈= unlevered firms, 𝑅𝐸= return on equity, 𝑅𝑂= return on unlevered equity, 𝑅𝐷= return on debt, D = market value of debt, E = market value of Equity, 𝑡𝑐= corporate tax rate.