Question

In the absence of taxes and perfect capital market assumptions what conclusions did Modigliani and Miller make about the relevance of the capital structure decision? Use numerical examples to support your answer.

Answer 1

Capital Structure Theory :

The Modigliani and Miller approach to the capital theory, formulated in the 1950s, advocates irrelevancy theory
of the capital structure.That implies a firm's valuation is unrelated to a company's capital structure. Whether a business is highly leveraged or has a lower portion of the debt has no effect on its market value. Rather, a firm's market value is solely based on the company's operating income.

A company's capital structure is the way an entity funds its properties. A business can fund its operations by either
equity or various debt / equity combinations. A company's capital structure may have a majority or majority of the
debt portion, or even a combination of both debt and equity.

Every solution has its own collection of risks and benefits. There are different theories of capital structure that seek to create a connection between a company's financial leverage the proportion of debt in the capital structure of the
company and its market value. The Modigliani and Miller Method is one such method. (Known As M&M Approach).

Modigliani and Miller (M & M) Approach :
This approach was designed by Modigliani and Miller (Known as M&M Approach) during the 1950s. 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 M & M Approach further notes that, aside from the risk involved in the company, A Firm’s M.V. is determined by it’s operating revenue or Income. The Approach has claimed that the firm’s valuation is not depending on the firm’s choiceof capital sytucture or funding decisions taken by any means.

In the absence of taxes and perfect capital market assumptions :
(Two Separate concepts without Taxes)

1) With the above mentioned "no taxes" assumptions, the capital structure does not influence a firm's valuation. To
put it simply, leveraging the company does not increase the company's market value. It also means that company
debt shareholders and equity shareholders have the same priority, i.e. profit are distributed evenly between them

2) It says the financial leverage is directly proportional to the equity costs. With the debt portion growing, the equity shareholders perceive a higher risk to the company. The shareholders therefore, expect a higher return in return, thereby increasing the cost of the equity. A key distinction here is that assumes debt shareholders have the upper or say priorities hand when it comes to earnings claims.
Therefore the debt burden is falling.