Mm capital structure theory pdf

Capital Structure Theory – Modigliani and Miller (MM) Approach

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.

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.

https://efinancemanagement.com/financial-leverage/capital-structure-and-its-theories
https://efinancemanagement.com/financial-leverage/capital-structure-and-its-theories
https://efinancemanagement.com/investment-decisions/value-of-a-firm
https://efinancemanagement.com/financial-leverage/capital-structure-and-its-theories
https://efinancemanagement.com/financial-leverage
https://efinancemanagement.com/financial-accounting/corporation
MODIGLIANI AND MILLER APPROACH: TWO PROPOSITIONS WITHOUT TAXES

PROPOSITION 1

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.

MODIGLIANI AND MILLER APPROACH: PROPOSITIONS WITH TAXES

M&M Theory 1’s assumption that there are no taxes is unrealistic. Taxes exist, and interest expense is

tax deductible i.e. the ultimate tax burden of a company with debt in its capital structure is lower than a

company with zero or lower debt. This brings us to M&M Theory 2 which relaxes the zero-tax

assumption.

https://efinancemanagement.com/sources-of-finance/shareholders-vs-stakeholders
Proposition 1

In a tax environment, the value of a levered company is higher than the value of an unlevered company

by an amount equal to the product of absolute amount of debt and tax rate.

This can be expressed mathematically as follows:

VL = VUL + t × D

Where VL is the value of levered company i.e. company with some debt in its capital structure, VUL is the

value of an un-levered company i.e. with no or lower debt, t is the tax rate and D is the absolute amount

of debt.

The Trade-off theory of capital structure

The trade-off theory states that the optimal capital structure is a trade-off between interest tax shields

and cost of financial distress:

Value of firm = Value if all-equity financed + PV(tax shield) - PV(cost of financial distress)

The trade-off theory can be summarized graphically. The starting point is the value of the all-equity

financed firm illustrated by the black horizontal line in Figure 10. The present value of tax shields is then

added to form the red line. Note that PV(tax shield) initially increases as the firm borrows more, until

additional borrowing increases the probability of financial distress rapidly. In addition, the firm cannot

be sure to benefit from the full tax shield if it borrows excessively as it takes positive earnings to save

corporate taxes. Cost of financial distress is assumed to increase with the debt level.

The cost of financial distress is illustrated in the diagram as the difference between the red and blue

curve. Thus, the blue curve shows firm value as a function of the debt level. Moreover, as the graph

suggest an optimal debt policy exists which maximized firm value.

In summary, the trade-off theory states that capital structure is based on a trade-off between tax savings

and distress costs of debt. Firms with safe, tangible assets and plenty of taxable income to shield should

have high target debt ratios. The theory is capable of explaining why capital structures differ between

industries, whereas it cannot explain why profitable companies within the industry have lower debt ratios

(trade-off theory predicts the opposite as profitable firms have a larger scope for tax shields and therefore

subsequently should have higher debt levels).

The pecking order theory of capital structure

The pecking order theory has emerged as alternative theory to the trade-off theory. Rather than

introducing corporate taxes and financial distress into the MM framework, the key assumption of the

pecking order theory is asymmetric information. Asymmetric information captures that managers know

more than investors and their actions therefore provides a signal to investors about the prospects of the

firm.

The intuition behind the pecking order theory is derived from considering the following string of

arguments:

 If the firm announces a stock issue it will drive down the stock price because investors believe

managers are more likely to issue when shares are overpriced.

 Therefore firms prefer to issue debt as this will allow the firm to raise funds without sending adverse

signals to the stock market. Moreover, even debt issues might create information problems if the

probability of default is significant, since a pessimistic manager will issue debt just before bad news

get out.

This leads to the following pecking order in the financing decision:

1. Internal cash flow

2. Issue debt

3. Issue equity

The pecking order theory states that internal financing is preferred over external financing, and if external

finance is required, firms should issue debt first and equity as a last resort. Moreover, the pecking order

seems to explain why profitable firms have low debt ratios: This happens not because they have low

target debt ratios, but because they do not need to obtain external financing. Thus, unlike the trade-off

theory the pecking order theory is capable of explaining differences in capital structures within

industries.