Question

What are the principles presented by Modigliani and Miller and explain your agreement or disagreement.

Answer 1

Modigliani- Miller approach

The principle behind the Modigliani -Miller approach to the capital theory was devised during the 1950s and this approach advocates the capital structure irrelevance theory. This theory states that the valuation of the firm is not relevant to the capital structure of the company.

The fundamentals of the Miller-Modigliani approach resembles the theory relevant to the Net Operating Income Approach. This theory states that a high leverage or a lower debt component in the financing mix does not carry any bearing on the value of the firm.. This theory also states that market value of a firm is greatly affected by its operating income in addition to the risk involved in the investments of a firm..

The value of the firm is not determined by the choice of the capital structure or the financial decisions of the firm.

This approach suggests two propositions without taxes

Proposition 1:

With the assumption of "no taxes", the capital structure does not in any way influence the valuation of a firm. This assumption means that leveraging the company does not increase the market value of the company.

Proposition 2:

This proposition states that financial leverage is directly related to the cost of equity. When the debt component increases, the equity shareholders may perceive a higher risk to the company. In turn, the shareholders may expect a higher return which may lead to an increase in the cost of equity.

The Modigliani-Miller approach suggest the following proposition with taxes:

This approach assumes that there are no taxes, which may not hold true in the real world situation. The interest paid on borrowed funds is tax deductible. This is not the case with the dividends paid on equity. This means that the actual cost of debt would be less than the nominal cost of debt.

Contribution by the M&M approach

As we all know, Modigliani and Miller have contributed a lot about Financial economics. As referred by Stern and Chow, Modigliani and Miller approach are considered to be the most popular and has created a huge impact on financial economic theory and development. almost all the economic authors have agreed upon that M & M has contributed beyond the proposition itself.

The most popular M&M proposition of dividend suggest that corporate values remains unaffected by the changes in the dividend policies. Though M&M approach lack the analytical power, authors still evaluate the importance of M&M propositions in relevance to the current financial economic theory.

Criticisms to Modigliani and Miller Approach

The following assumptions of Miller and Modigliani approach are being criticized to a great extent:

(i) individuals and firms can borrow at the same market rate and that

(ii) bankruptcy does not actually exist

According to Stiglitz (1969), the practice suggests that there are at least certain limitations that arise towards the market rates for the individuals at the stage of borrowing in comparison to firm's borrowing. Further, bankruptcy is assumed to be more violent and may pose a problem to the firms much more than it was assumed by the Miller and Modigliani proposition.

We can conclude that M&M propositions were created based on the non-real market conditions but they still offer the economists with the opportunity for further improvisation and new theories regarding two issues as suggested by those propositions.