# Modigliani-Miller (M-M) Approach

After reading this article you will learn about Modigliani-Miller (M-M) Approach:- 1. Proposition of M-M Approach 2. Assumptions of M-M Approach 3. Interpretation 4. Proof 5. Criticisms 6. M-M Approach with Corporate Taxes and Capital Structure.

Contents:

1. Proposition of M-M Approach
2. Assumptions of M-M Approach
3. Interpretation of M-M Approach
4. Proof of M-M Approach
5. Criticisms of M-M Approach
6. M-M Approach with Corporate Taxes and Capital Structure

#### 1. Proposition of M-M Approach:

ADVERTISEMENTS:

The following propositions outline the MM argument about the relationship between cost of capital, capital structure and the total value of the firm:

(i) The cost of capital and the total market value of the firm are independent of its capital structure. The cost of capital is equal to the capitalisation rate of equity stream of operating earnings for its class, and the market is determined by capitalizing its expected return at an appropriate rate of discount for its risk class.

(ii) The second proposition includes that the expected yield on a share is equal to the appropriate capitalisation rate for a pure equity stream for that class together with a premium for financial risk equal to the difference between the pure-equity capitalisation rate (K.) and yield on debt (Kd). In short, increased Ke is offset exactly by the use of cheaper debt.

(iii) The cut-off point for investment is always the capitalisation rate which is complete­ly independent and unaffected by the securities that are invested.

#### 2. Assumptions of M-M Approach:

The MM proposition is based on the following assumptions:

(a) Existence of Perfect Capital Market:

ADVERTISEMENTS:

It includes that:

(i) There is no transaction cost;

(ii) Floatation cost is neglected;

(iii) No investor can affect the market price of shares;

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(iv) Information is available to all without cost;

(v) Investors are free to purchase and sale of securities.

(b) Homogeneous Risk Class/Equivalent Risk Class:

It means that the expected yield/return have the identical risk factor, i.e., business risk is equal among all firm having equivalent operational condition.

ADVERTISEMENTS:

(c) Homogenous Expectation:

All the investors should have identical estimate about the future rate of earnings of each firm.

(d) The Dividend Pay-out Ratio is 100%:

It means that the firm must distribute all of its earnings in the form of dividend among the shareholders/investors, and

(e) Taxes do not Exist:

That is, there will be no corporate tax effect (although this was removed at a subsequent date).

#### 3. Interpretation of M-M Approach:

The MM Hypothesis reveals that if more debt is included in the capital structure of a firm, the same will not increase its value as the benefits of cheaper debt capital are exactly set off by the corresponding increase in the cost of equity, although debt capital is less expensive than the equity capital.

So, according to M-M, the total value of a firm is absolutely unaffected by the capital structure (debit-equity mix) when corporate tax is ignored.

#### 4. Proof of M-M Approach: The Arbitrage Mechanism:

MM has suggested an arbitrage mechanism in order to prove their argument.

They argued that if two firms differ only in two points viz.

(i) The process of financing and

(ii) Their total market value, the shareholders/investors will dispose of share of the over-valued firm and will purchase the share of under-valued firms and naturally this process will be going on till both of them will attain the same market value.

As such, as soon as the firms will reach at the identical position, the average cost of capital and the value of the firm will be equal So, total value of the firm (V) and Average Cost of Capital Kw are independent.

It can be explained with the help of the following illustration:

Let there are two firms, viz., Firm-‘A’ and Firm-‘B’. They are similar in all respects except in the composition of capital structure. Assuming that Firm-‘A’ is financed only by equity whereas Firm-‘B’ is financed by a debt-equity mix.

The following particulars are presented below:

From the table presented above, it is learnt that value of the levered firm ‘B’ is higher than the unlevered firm ‘A’. According to MM, such situation cannot persist long as the investors will dispose of their holding 01 firm ‘B’ and purchase the equity from the firm ‘A’ with personal leverage. This process will be continued till both the firms will have same market value.

Suppose, Ram, an equity shareholder, has 1% equity of firm-‘B’. He will do the following:

(i) At first, he will dispose of his equity of firm-‘B’ for Rs. 3,333.

(ii) He will take a loan of Rs. 2,000 at 5% interest from personal account.

(iii) He will purchase by having Rs. 5,333 (i.e., Rs. 3,333 + Rs. 2,000) 1.007% of equity from the firm ‘ A’.

By this, his net income will be increased as under:

Obviously, this net income of Rs. 433 is higher than that of the firm ‘B” by disposing of 1% holding.

It is needless to say that when the investors will sell the shares of the firm ‘B’ and will purchase the shares from the firm ‘A’ with personal leverage, this market value of the share of firm ‘A” will decline and consequently the market value of the share of firm ‘B’ will rise and this will be continued till both of them attain the same market value.

We have explained that the value of the levered firm cannot be higher than that of the unlevered firm (other thing being equal) due to the arbitrage process. We will now highlight the reverse direction of the arbitrage process.

Consider the following illustration:

In the above circumstances, equity shareholders of the firm ‘A’ will sell his holdings and by the proceeds he will purchase some equity from the firm ‘B’ and invest a part of the proceeds in debt of the firm ‘B’.

For instance, an equity shareholder holding 1% equity in the firm ‘A’ will do the following:

(i) He will dispose of his 1% equity of firm ‘A’ for Rs. 6,250.

(ii) He will buy 1 of equity and debt of the firm ‘B’ for the like amount.

(iii) As a result, he will have an additional income of Rs. 86.

Thus, if the investors prefer such a change, the market value of the equity of the firm ‘ A” will decline and consequently the market value of the shares of the firm-‘B’ will tend to rise and this process will be continued till both the firms attain the same market value i.e., the arbitrage process can be said to operate in the opposite direction.

#### 5. Criticisms of the M-M Approach:

We have seen (while discussing M-M Hypothesis) that M-M Hypothesis is based on some assumptions. There are some authorities who do not recognise such assumption as they are quite unrealistic, viz. the assumption of perfect capital market. We also know that most significant element in this approach is the arbitrage process forming the behavioural foundation of the M-M Hypothesis.

As the imperfect market exist, the arbitrage process will be of no use and as such, the discrepancy will arise between the market value of the unlevered and levered firms. The followings are the shortcomings for which arbitrage process fails to bring the equilibrium condition.

(i) Existence of Transaction Cost:

The arbitrage process is affected by the transaction cost. While buying securities, this cost is involved in the form of brokerage or commission etc. for which extra amount is to be paid which increase the cost price of the shares and requires a greater amount although the return is same. As such, the levered firm will enjoy a higher market value than the unlevered firm.

(ii) Assumption of Borrowing and Lending by the Firms and the Individual at the Same Rate of Interest:

The above proposition, that is, the firms and the individuals can borrow or lend at the same rate of interest, does not hold good in reality. Since a firm holds more assets and credit reputation in the open market in comparison with an individual, the former will always enjoy a better position than the later.

As such, cost of borrowing will be higher in case of individual than the firm. As a result the market value of both the firms will not be equal.

(iii) Institutional Restriction:

The arbitrage process is retarded by the institutional investor e.g., Life Insurance Corporation of India, Commercial bank. Unit Trust of India etc., i.e., they do not encourage personal leverage. At present these institutional investors dominate the capital market

(iv) “Personal or Home-made, leverage” is not the perfect substitute for “Corporate leverage.”

M-M Hypothesis assumes that “personal leverage” is a perfect substitute for “corpo­rate” leverage which is not true as we know a firm may have a limited liability whereas there is unlimited liability in case of individuals. For this purpose, both of them have a different footing in the capital market.

(v) Incorporation of Corporate Taxes:

If corporate taxes are considered (which should be taken into consideration) the M-M approach will be unable to discuss the relationship between the value of the firm and the financing decision. For example we know that interest charges are deducted from profit available for dividend i.e., it is tax deductible.

In other words, the cost of borrowing funds is comparatively less than the contractual rate of interest which allows the firm regarding tax advantage. Ultimately, the benefit is being enjoyed by the equity holders and debt holders.

According to some critics the arguments which were advocated by M-M, are not valid in the practical world. We know that cost of capital and the value of the firm are practically is the product of financial leverage.

#### 6. M-M Approach with Corporate Taxes and Capital Structure:

The M-M Hypothesis is valid if there is perfect market condition. But in the real world capital market, imperfection arises in the capital structure of a firm which affect the valuation. Because; presence of taxes invites imperfection.

We are, now, going to examine the effect of corporate taxes in the capital structure of a firm along with the M-M Hypothesis. We also know that when taxes are levied on income, debt financing is more advantageous as interest paid on debt is a tax-deductible item whereas retained earnings or dividend so paid on equity share are not tax deductible.

Thus, if debt capital is used in the total capital structure, the total income which is available for equity shareholders and/or debt holders will be more. In other words, the levered firm will have a higher value than the unlevered firm for this purpose, or, it can alternatively be stated that the value of the levered firm will exceed the unlevered firm by an amount equal to debt multiplied by the rate of tax.

The same can be explained in the form of the following equation:

Illustration:

Solution:

Thus, a firm can lower its cost of capital continuously due to the tax deductibility of interest charges. So, a firm must use the maximum amount of leverage in order to attain the optimum capital structure although the experience that we realise is contrary to the opinion.

In real world situation, however, firms do not take a larger amount of debt and creditors/ lenders also are not interested to supply loan to highly levered firms due to the risk involved in it.

Thus, due to the market imperfection, after tax cost of capital function will be U- shaped. In answer to this criticism, M-M suggested that the firm would adopt a target debt ratio so as not to violate the limits of level of debt imposed by creditors. This is an indirect way of stating that the cost of capital will increase sharply with leverage beyond some safe limit of debt.

M-M Hypothesis with corporate taxes can better be presented with the help of the following diagram:

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