Question

1. What are the MM propositions? Explain the financial theories, what their assumptions are, how they are related, and what they tell financial managers.

Answer 1

Modigliani-Miller Theory propositions:

1. value of a company is calculated as the PV of future cash flows and its underlying assets, and the capital structure of the company has no role to play in it. Thus it is irrelevant whether a company raises funds via equity, debt or preference capital.

2. Financial leverage in fact increases the value of the firm by reducing the WACC. Provided there are no taxes.

Traditional Approach mentions that the value of a Firm is affected by the capital strcture of the company. An optimal capital structure would lead to the minimum cost of capital and inturn will maximise the Firm's value.

Net Income Approach which says that the firm's value and stock price is maximised at the lowest cost of capital which is achieved by including more debt in the capital structure. This holds true when cost of debt is less than cost of equity, there are no taxes, increasing debt doesnt affect the risk levels.

Net Operating Income Approach states the following:

1. the overall capitalization rate of the firm is constant for all degree of leverages

2. Net operating income is capitalized at the overall capitalization rate to arrive at the market value of firm

3. market value of equity= overall firm value- market value of debt