Modigliani and Miller Approach is a modern approach to capital Structure Theory. It supports the irrelevancy theory which suggests that the firm valuation is irrelevant to the company’s capital structure. The firm has no bearing on its value whether it has a lower debt or it is highly leveraged. According to the MM approach, the firm’s market value is affected by its future growth. Resulting from high growth prospect, the stock prices are high as a result of higher market value.
The market value of a firm is low when investors fail to see attractive growth prospects in it. There are several assumptions of the MM approach which include zero taxes and that there is no transaction cost for buying and selling securities. Another assumption is that there is the same cost of borrowing for both investors and companies. If the future prospects of operating profits are same, the value of leverage firm is the same as the value of the unleveraged firm. The MM approach to two propositions without taxes suggests that in the company, equity shareholders and debt holders have the same priority. The second proposition says that as far as earnings claim is concerned, debt-shareholders have upper-hand, therefore, reducing the cost of the debt. MM approach to propositions with taxes assumes that there are nil taxes which is not true since almost all countries tax a company. The case is different with dividends which are paid on equity.
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As a result of the tax benefits, the debts actual cost is less than its nominal cost. With corporate taxes, the approach acknowledges tax savings which imply that the Weight Average Cost of capital is affected by changes in debt-equity ratio.
References
Casey, C. (2016). Risk Class Completion of the Modigliani and Miller Model–A New Framework for Discounted Cash Flow.
Ghosh, A. (2017). Capital structure and firm performance . Routledge.
Vishny, R., & Zingales, L. (2017). Corporate Finance. Journal of Political Economy , 125 (6), 1805-1812.
