Question

The answer should have some critical thinking and class concepts -(Corporate Financial Management). Do not exceed 650 words. You are allowed to cite websites and have references. Thanks.

In your own words, describe the M&M theory i.e. choose one of the two propositions, include how it benefits/affects the company and/or the shareholders.

Answer 1

Modigliani-Miller (M&M) Theory :-

The basic theory of Modigliani-Miller approach is that the changes in the capital structure do not affect the total value of the firm. The reason being that the debt capital is cheap and its more use in capital structure results into high expectation of equity shareholders and this raises the cost of equity capital and therefore, the benefits of low debt cost are offset exactly by the increase in cost of equity capital.

i).M&M theory in absence of corporate taxes :- If there are no taxes then the changes in capital structure of any company do not bring any change in the overall cost of capital and total value of company. The reason being that the debt capital is cheap and its more use in capital structure results into high expectations of equity shareholders and this raises the cost of equity capital and therefore the benefits of low debt cost are offset exactly by the increase in cost of equity capital.

ii). M&M theory in presence of corporate taxes :- In the presence of corporate taxes, The total value of firm can be calculated as under :-

Value of unlevered firm = Earnings before interest and taxes * (1 - Tax rate) / Equity capitalization rate

Value of levered firm = Value of unlevered firm + Debt value * Tax rate.

Accordingly,The total value of a levered company is high than the non-levered company. Therefore, in the presence of tax base, if any company uses debt in its capital structure, it leads to reduction in overall cost of capital for the company and increase in the value of company.