M.M CAPITAL STRUCTURE THEORY

M.M capital structure theory

The M.M Capital structure theory presented by two economists Modigliani and Millar in 1950s.They developed the capital structure irrelevance proposition. They hypnotized that is a perfect market, it does not matter what the company capital structure use to finance its operations also market value of firm determined by its earning power and by the risk of its underline assets, and its value is independent of the way its choose to finance to its distribution of dividend.

 The basic M&M proposition is base on the following assumption:-

Ø  No tax.

Ø  No transaction cost.

Ø  No bankruptcy cost.

Ø  The cost of borrowing is the same for investors and companies.

Ø  There is no corporate dividend tax.

Ø  There is no flotation cost like underline commission, payment of merchants banker’s, advertisement expenses etc.

Ø  No effect of debt on a company earning before earning and tax.

In the real world, there is transaction cost, bankruptcy cost; taxes are there, information asymmetric and effect of debt on earnings.

Modigliani and Millar capital structure irrelevance proposition:-

The irrelevance proposition is a theory of corporate capital that structure asserts financial leverage doesn’t affect the value of firm if income tax and distress cost are not considered in a business environment. The cost of equity directly links with gearing. As gearing increases the financial risk to shareholders increase. The weighted average cost of capital, the total value of the company and shareholder wealth are constant and unaffected by gearing level.

Braking down irrelevance proposition

In developing their theory, Modigliani and Millar first they assumed that the firm has two ways of obtained funding; equity and debt. While each type of funding has own benefits and drawbacks the outcome is a firm dividing up its cash flows to investor regardless of the funding source choose. If all investor has access to the same financial market than the investor can buy into or sell out of a firm’s cash flows at any point. A criticism of their irrelevance proposition theory focused on the lack of realism is removing the effect of income from a capital structure. Because many factors influence the firm value, including profit, assets and market opportunities, testing the theorem is difficult.

Trade-off the theory of capital leverage

The static trade of theory is a financial theory based on the work of economists Modigliani and Millar. With static trade-off theory, the company’s debt payments are tax deductible and there less risk involved in taking out debt over equity, Debt financing is initially cheaper than equity finance. The increase of debt also increases the risk to the company somewhat offset the decrease weighted average cost of capital. Basically, the tradeoff theory a mix of debt and equity where the decrease weighted average cost of capital offsets the increasing financial risk to a company.

Capital Structure Theory
Bankruptcy Cost

Value of the firm = value of all equity financed + PV (tax shield) – PV (cost of financial distress)The theory recognized the tax benefits from interest payments that are because interest paid on debt is tax deductible, issuing bounds effectively reduces company’s tax liability. Paying dividend on equity whatever does not. Another way the actual rates of interest companies pay on the bounds the issue is less than the nominal rate of interest because of tax savings. Cost of financial distress is assumed to increases with the debt level.