Question

Modigliani and Miller developed a theory describing a firm’s optimal capital structure, ranging from a basic model assuming no corporate taxes, to an intermediate model including corporate taxes, and ultimately a model providing for costs of financial distress.
Do you agree or disagree that "all three models are practically applicable in the real world". Justify your comment

Answer 1

First Version with no taxes:

The first version of the M&M Theorem with the assumption of perfectly efficient markets. The assumption implies that companies operating in the world of perfectly efficient markets do not pay any taxes, the trading of securities is executed without any transaction costs, bankruptcy is possible but there are no bankruptcy costs, and information is perfectly symmetrical.

Shortcomings:

The first version is hardly applicable in the real world since perfectly efficient markets do not exist. There is always some information not available to public, there are transaction costs associated with provision of facilities of movement of money and borrowing of capital and there are costs associated with bankruptcy that include litigation costs, costs of settlement of debts etc.

Effect of Taxes

market values of firms in each risk class are also a function of the tax rate and the degree of leverage. Since the corporation tax is based on income after deduction of interest payments on debt but before dividend payments two identical companies with respect to their cash flows pay different amount of tax if their capital structures are different. That is, a company with debt will have more post-tax income than an unlevered company

Second Version:

The second version of the M&M Theorem was developed to better suit real-world conditions. The assumptions of the newer version imply that companies pay taxes; there are transaction and agency costs; and information is not symmetrical.

Shortcomings:

The model yet failed to consider bankruptcy costs since such costs lead to reduction in value of the firm. Financial economists thus suggested theories which incorporate these costs into the capital structure models to serve as a trade-off against the tax benefit of debt financing and hence fill the gap between the MM prediction and observed capital structures of firms

Even in case of costless bankruptcy, the theorem does not depend on the existence of risk classes, on the competitiveness of capital markets, or on the homogeneous expectations of investors.

Bankruptcy Costs

As long as bankruptcy costs are zero risky debt has no effect on the value of the firm and the value of the firm is equal to the value of the discounted cash flows from investment. The division of these cash flows between risky debt and risky equity does not matter. However, when bankruptcy costs are introduced this is no longer true.

Costs associated with bankruptcy may take different forms:

There are direct (out-of-pocket) costs which include legal, administrative, and advisory fees paid by the firm. Second, there are indirect bankruptcy costs which arise because financial distress affects the company's ability to conduct its business. For example, financial distress can reduce the finn's sales or increase its production costs. These costs results in the value of the firm in financial distress (or in bankruptcy) being less than the expected cash flows from operation.

Hence, only the third version whinch incorporates the effect of financial distress and bankruptcy costs and effect of taxes is practically applicable in real world.

Conclusion

Financial risk is the result of fmancial leverage which, since it is a fixed cost source of funds, increases the variability of earnings per share (EPS) and the probability of bankruptcy.