Question

The answer should have some critical thinking and class concepts -(Corporate Financial Management). Do not exceed 150 words. Make sure the answer is well written and correct. Thanks.

Question is Below:

The financial structure under the M&M theory has no bearing on the value of the firm. Do you know the reason for this?

Hint: Has to do with the accounting equation.

Answer 1

The fundamentals of the Modigliani and Miller Approach resemble that of the Net Operating Income Approach. Modigliani and Miller advocate capital structure irrelevancy theory, which suggests that the valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or has a lower debt component in the financing mix has no bearing on the value of a firm.

The Modigliani and Miller Approach further states that the market value of a firm is affected by its operating income, apart from the risk involved in the investment. The theory stated that the value of the firm is not dependent on the choice of capital structure or financing decisions of the firm.

ASSUMPTIONS OF MODIGLIANI AND MILLER APPROACH

• There are no taxes.
• Transaction cost for buying and selling securities, as well as the bankruptcy cost, is nil.
• There is a symmetry of information. This means that an investor will have access to the same information that a corporation would and investors will thus behave rationally.
• The cost of borrowing is the same for investors and companies.
• There is no floatation cost, such as an underwriting commission, payment to merchant bankers, advertisement expenses, etc.
• There is no corporate dividend tax

The Modigliani and Miller Approach indicates that the value of a leveraged firm (a firm that has a mix of debt and equity) is the same as the value of an unleveraged firm (a firm that is wholly financed by equity) if the operating profits and future prospects are same. That is, if an investor purchases shares of a leveraged firm, it would cost him the same as buying the shares of an unleveraged firm.