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What are the key assumptions of Modigliani-Miller (M&M) Theorem?
The first version of the M&M theorem (or M&M Theorem I) considers a perfect and hypothetical market condition. In such a case, the market is completely efficient, which implies the markets are working smoothly with all information being conveyed to the investors taking part in it. The theorem also considers that there are no taxes, no trading costs of equity, and bankruptcy being applicable without bankruptcy costs.
The Key Assumptions of M&M Theorem
The theorem follows certain assumptions depending on the market conditions, risks, tax liabilities, and dividend payout. The assumptions are as follows −
Perfect Capital Markets
The perfect market condition applies to the securities that are traded in a share market. It makes sure that the investors of the market can buy or sell securities without any restrictions.
The investors in a perfect market are allowed to borrow at the same cost at which they lend, and they invest rationally.
It is also implied that there are no transaction costs that have to be made in the process.
Also, the corporate leverage and homemade leverage should be the same for both corporate and individual investors.
Homogenous Risk Classes
There are companies in the market that fall within certain homogenous classes. There may be classes depending on the nature of industries that cause the same homogenous risks for the firms. These companies are believed to have similar operating risks and they fall within the same groups considering the risks they are subjected to.
The risks associated with the firms arise from the operating risks and are defined in terms of Net Operating Income (NOI). The risk to investors arises both from fluctuations of NOI and the fact that there may be variance in the actual outcome of risk due to variables that affect the outcome.
In other words, the risks of the firms originate from the fluctuations of NOI and the possibility that the value of actual variables may be different from the actual estimates.
The theorem considers that there is no tax payable by the firms. This means that there is no tax saving from the interest payable to debts. Tax deductions not being applicable, the companies may have to incur no costs in taxes that are liable to be paid otherwise.
Full Dividends Payout
The theorem states that the companies must pay all net earnings to the shareholders. In other words, the company should distribute 100% of its net earnings as dividends.
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