Question

M-M theory (1958) what could possibly be the most important theory for the structure of capital, through which it explains the effect of the capital structure for the value of companies that the firm’s value and cost of capital are autonomous of the capital structure decision and as such debt is irrelevant in determining a company’s cost of capital.

Assess and make a critical review of Modigliani and Miller's Theory and the dominating literature that is pro and against this theory, aiming to identify the theory's importance and contribute to the field modern finances.                                                                    

Answer 1

Modigliani and Miller's Theory of capital structure

In order to develop the theory, Modigliani and Miller used the concept of arbitrage. When arbitrage occurs simultaneous buying and selling of levered and unlevered stocks will be continued till the prices of these two stocks are equal. These two stocks must be similar, only then the arbitrage process will operate. Thus MM theory proposes that capital structure decision is irrelevant for value of the firm and cost of capital.

The theory is based on few assumptions. It was the assumptions of this theory which attracted many criticisms.

Critical review of Modigliani and Miller's Theory

1. The famous proposition of MM theory is irrelevance of dividend decision. Many literatures have proved the relevance of capital structure and dividend decisions. That proportion has been criticized by many people
2. Another assumption is that the individuals and firms can borrow and lend at same interest rate. This is not right. Firms can avail debt cheaper than individuals if they have sufficient asset base
3. Another assumption of "there are no transaction costs and bankruptcy"' also has criticism. It is not possible in practice. Transaction costs do exist.
4. MM theory assumes that the tax advantage from corporate debt will be constant regardless of the amount of debt used. This cannot be correct. Because tax advantage vary from firm to firm.
5. It is assumed that there are no costs related to financial distress. Thus agency costs are ignored. This is not practical.
6. Further assumption is that all the market participants have identical information about the firm. This is also incorrect.

Though this theory suffers from these limitations, MM theory is considered to be very important by many authors of studies in modern finance and was evaluated by many Economists. MM theory was criticised by many because the world imagined by the authors of the theory was bit different from the real world. But the theory has discussed the latest concepts of modern corporate finance.