What is the Modigliani and Miller Capital structure theory, and the assumptions of the theories? What are Proposition I and Proposition II?

The main rationale behind the theorem is that tax-deductible interest payments positively affect a company’s cash flows. Since a company’s value is determined as the present value of the future cash flows, the value of a levered company increases. The financial structure of a firm comprises the various ways and means of raising funds.’ In other words, financial structure includes all long-term and short-term liabilities.

When capital structure is composed of more than one source or identical nature, the same is known as Complex Capital Structure. In other words, if the capital structure is composed of Equity Share Capital, Preference Share Capital, Retained Earnings, Debentures, Long-term Loans and Current Liabilities etc., the same is known as complex capital structure. Capital structure refers to the permanent financing of the company, represented by owned capital and loan/debt capital (i.e., Preferred Shares, Equity Shares, Reserves and Long-term Debts).

M&M Theorem

But if short-term (i.e. current liabilities) liabilities are excluded the same is known as net worth or capital structure. The above equations are used by all capital structure theories, only the controversy lies in relation to the degree of leverage of the variable cost of equity (Ke), weighted average cost of capital (Kw) and total firms value (V). The above equations are used by all capital structure theories, the controversy only lies in relation to the degree of leverage of the variable cost of equity (Ke), weighted average cost of capital (Kw), and total firm’s value (V). In other words, the decisions of capital structure affect the value of the firm by the returns that are made available for the equity shareholders. In order to maximise the value of the equity shares, the firm must have to choose a financing mix-capital structure which will assist to achieve the desired objectives. Thus, the capital structure must be tested from the point of view of its effect towards the value of the enterprise.

The theory of the traditional structure of valuing a firm suggests that there is an optimal debttoequity ratio that has a minimum overall cost of capital and maximum market value of a firm. On the sides of this point, changes in the financing mix can bring positive changes to the value of a firm. Moreover, before this point, the marginal cost of debt is less than the equity cost; and after this point, the cost of equity is less than the cost of debt. The traditional approach to capital structure assumes that an increase in the proportion of debt to some extent does not result in an increase in the cost of equity, i.e., it remains fixed or grows slightly. That is the reason why it becomes possible to reduce the weighted average cost of capital (WACC) by increasing the proportion of debt financing in total capital.

Capital Structure: Definition, Assumptions and Classification

Thus, from the above, it is quite clear that the capital structure of Company X is low-geared, Company Y is evenly geared and Company Z is high geared. The higher the gear, the more speculative will be the character of equity shares, since, under this condition, dividend on equity fluctuates disproportionately with the amount of divisible profits. Capital structure refers to the permanent financing of the company, represented by owned capital and loan/debt capital (i.e.. Preferred Stock, Equity Stock, Reserves and Long- term Debts). In other words, it includes all long-term funds invested in the business in the form of Long-term Loans, Preference Shares and Debentures, including Equity Capital and Reserves.

• Total capital of STAR S.E. Inc. is $3,000,000 and expected earnings before interest and taxes are $510,000.
• Thus, from the above, it is quite clear that the capital structure of Company X is low-geared, Company Y is evenly geared and Company Z is high geared.
• When the optimal capital structure is reached, the value of a firm is maximized as shown in the figure below.
• Therefore, the company with a 100% leveraged capital structure does not obtain any benefits from tax-deductible interest payments.

The Modigliani-Miller theorem argues that the option or combination of options that a company chooses has no effect on its real market value. Gain unlimited access to more than 250 productivity Templates, CFI’s full course catalog and accredited Certification Programs, hundreds of resources, expert reviews and support, the chance to work with real-world finance and research tools, and more.

Net Operating Income Approach of Capital Structure

Therefore, investors tend to demand a higher cost of equity (return) to be compensated for the additional risk. As regards capital structure, the significant point to be noted is the proportion of owned capital and borrowed capital by way of different securities to the total capitalisation for raising finance. Long-term funds can be raised either by the issue of (a) Shares, or (b) Debentures or long-term loans and borrowings. The Modigliani-Miller theorem (M&M) states that the market value of a company is correctly calculated as the present value of its future earnings and its underlying assets, and is independent of its capital structure.

The Modigliani and Miller (M&M) theory examines the impact of a firm’s capital structure on its value. The theory’s basic premise is that the firm’s value is equal to the present value of the sum of its future cash flows. To the extent that these cash flows are impacted by its financing (use of debt and equity), the impact of capital structure on firm value hinges on taxation. An increase or decline in the optimal structure of capital affects the value of a firm. Hence, when the overall cost of capital is diminished up to a specific level of debt, the optimal capital structure comes into effect to increase the value of a company. Fixed cost financing sources cause the firm’s earnings per share to change at a rate greater than the change in operating income.

Assumptions under the Traditional Approach

When the capital structure is composed of Equity Capital only or with Retained earnings, the same is known as Simple Capital Structure. The minimum cash balance you select is somewhat arbitrary, and is a function of sales, industry, and other unquantifiable factors. Company management will have a pretty good idea of what figure to use, as might more senior investment bankers. Assumptions of the traditional approach to capital structure are illustrated in the figure below.

The minimal value of WACC is reached when the marginal cost of debt equals the marginal cost of equity. A further increase of financial leverage will result in an increase of WACC as far as the marginal cost of debt will be higher than the marginal cost of equity due to higher risks. From theoretical point of view capital structure affects either cost of capital or expected yield or both of a firm.

The traditional theory of capital structure says that a firm’s value increases to a certain level of debt capital, after which it tends to remain constant and eventually begins to decrease if there is too much borrowing. This decrease in value after the debt tipping point happens because of overleveraging. On the other hand, a company with zero leverage will have a WACC equal to its cost of equity financing and can reduce its WACC by adding debt up assumptions of capital structure to the point where the marginal cost of debt equals the marginal cost of equity financing. In essence, the firm faces a trade-off between the value of increased leverage against the increasing costs of debt as borrowing costs rise to offset the increase value. Beyond this point, any additional debt will cause the market value and to increase the cost of capital. The cost structure of value is also known as the capital structure of valuing a firm.

The revolver assumption is somewhat arbitrary as well, but should be large enough so that the revolver is not overdrawn and your cash balance never falls below your specified minimum (or zero, which is, of course, impossible). In fact, we’ll design this model to prevent you from going below your minimum cash balance and, instead, violate your revolver limit and generate error messages. If, when building your model, you find that your revolver assumption is too small, simply assume a larger number.

According to Solomon, E, the same is defined as ‘that capital structure or combination of debt and equity that leads to the maximum value of the firm’. Thus, we cannot ignore the importance of capital structure of a firm as we believe that there is a clear relationship between the value of the firm and the capital structure although some others do not accept it. If funds are raised by the issue of equity shares, it requires dividends only if there is sufficient profits, whereas, in the latter case, it requires a fixed rate of interest irrespective of the profit or loss. Thus, the question of capital gearing arises as to on which fund a fixed rate of interest or dividend is paid. Thus, the question of capital gearing arises relating to which fund a fixed rate of interest or dividend is paid.

The first proposition essentially claims that the company’s capital structure does not impact its value. Since the value of a company is calculated as the present value of future cash flows, the capital structure cannot affect it. Therefore, the company with a 100% leveraged capital structure does not obtain any benefits from tax-deductible interest payments.

The second proposition for the real-world condition states that the cost of equity has a directly proportional relationship with the leverage level. This is the first version of the M&M Theorem with the assumption of perfectly efficient markets. The assumption implies that companies operating in the world of perfectly efficient markets do not pay any taxes, the trading of securities is executed without any transaction costs, bankruptcy is possible, but there are no bankruptcy costs, and information is perfectly symmetrical. There are two types of capital structure according to the nature and type of the firm, viz, (a) Simple and (b) Complex.

• Fixed cost financing sources cause the firm’s earnings per share to change at a rate greater than the change in operating income.
• It is needless to mention that a firm must choose its financing-mix in such a manner so that it maximises the shareholders’ fund if the capital structure of the firm affects the total value of the enterprise which, in other words, goes by the name of Optimum Capital Structure for the firm.
• An income statement demonstrates the company’s income and expenses over a given timeframe, used to reflect performance.
• According to Solomon, E, the same is defined as ‘that capital structure or combination of debt and equity that leads to the maximum value of the firm’.

At the time, both Modigliani and Miller were professors at the Graduate School of Industrial Administration at Carnegie Mellon University. Both were required to teach corporate finance to business students but, unhappily, neither had any experience in corporate finance. After reading the course materials that they were to use, the two professors found the information inconsistent and the concepts flawed.

Let us make an in-depth study of the meaning, assumptions and classification of the capital structure. The calculations above prove that the value of STAR S.E. Inc. will be maximized at a debt ratio of 0.30. We know that a firm obtains its requirement from various sources and invest the same also in various forms of assets. Although a firm may start with the ‘Simple’ type, the same is converted into a ‘Complex’ one in course of time. Merton Miller and Franco Modigliani conceptualized and developed this theorem, and published it in an article, “The Cost of Capital, Corporation Finance and the Theory of Investment,” which appeared in the American Economic Review in the late 1950s.

Management of STAR S.E. Inc. may reach the minimum WACC of 15.5% when its capital structure is represented by 30% of debt and 70% of equity. When the optimal capital structure is reached, the value of a firm is maximized as shown in the figure below. One of the primary assumptions of capital structure analysis is that the level and variability of _____ is not expected to change as changes in capital structure are contemplated. The first version of the M&M theory was full of limitations as it was developed under the assumption of perfectly efficient markets, in which the companies do not pay taxes, while there are no bankruptcy costs or asymmetric information. Subsequently, Miller and Modigliani developed the second version of their theory by including taxes, bankruptcy costs, and asymmetric information. Capital gearing stands for the determination of proportion of various kinds of securities to the total capitalisation.