Question

MM argue that in a world with no taxes and bankruptcy costs, capital structure does not matter. Why is this the case? How will their argument change in the real world? Discuss. Please illustrate your answer with the appropriate graph

Answer 1

Answer-:

The Modigliani and Miller approach to capital theory, devised in the 1950s, advocates the capital structure irrelevancy theory. This 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 has no bearing on its market value. Rather, the market value of a firm is solely dependent on the operating profits of the company.

The capital structure of a company is the way a company finances its assets. A company can finance its operations by either equity or different combinations of debt and equity. The capital structure of a company can have a majority of the debt component or a majority of equity, or an even mix of both debt and equity. Each approach has its own set of advantages and disadvantages. There are various capital structure theories that attempt to establish a relationship between the financial leverage of a company (the proportion of debt in the company’s capital structure) with its market value. One such approach is the Modigliani and Miller Approach.

The Modigliani and Miller Approach assumes that there are no taxes, but in the real world, this is far from the truth. Most countries, if not all, tax companies. This theory recognizes the tax benefits accrued by interest payments. The interest paid on borrowed funds is tax deductible. However, the same is not the case with dividends paid on equity. In other words, the actual cost of debt is less than the nominal cost of debt due to tax benefits. The trade-off theory advocates that a company can capitalize its requirements with debts as long as the cost of distress, i.e., the cost of bankruptcy, exceeds the value of the tax benefits. Thus, the increased debts, until a given threshold value, will add value to a company.

The basic theorem states that in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. Since the value of the firm depends neither on its dividend policy nor its decision to raise capital by issuing stock or selling debt, the Modigliani–Miller theorem is often called the capital structure irrelevance principle.

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