Question

The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) is an influential element of economic theory; it forms the basis for modern thinking on the capital structure of a firm. The MM theorem represents what could possibly be the most important theory in respect of the effects of the Capital structure of a firm and the value of that firm. Despite the enormous efforts by Modigliani and Miller and the entire time spent by numerous scholars critiquing this theory, the MM theorem remains unclear and faces many objections. Critically discuss. (25marks) (Word count limit 500-1000)

Answer 1

The M&M approach stated that the value of the does not get affected by the change in the capital structure of the firm.

The financial economists do apply this approach and find it very useful practically. But to some of the economists, it was unclear and it raised many objections too. Some issues or criticism related to the approach are as follows:

1. corporate tax - As it has mentioned in the assumptions that, taxes are neutral and it was built when there were no taxes, but in actual, taxes are not neutral as they have an impact on the firm.

2. Transaction cost - Transaction cost also has an impact on the value of the firm as the transaction cost interface with the working of the arbitrage.

3. The assumptions of the M&M approach is based on the partial equilibrium analysis, not on general equilibrium analysis which makes it difficult to understand and thus the economist left with the unclear terms.

4. It is also criticized for the assumption that it assume the bankruptcy does not exist which is not true. Bankruptcy exist in today's term and it affects the firm very badly.

5. As the assumption, this approach has assumed that no taxes, no bankruptcy, no transaction cost, no risk, markets are perfect, It shows that they imagined the controlled environment while making this theory. But in the recent era, the markets are not controlled and thus this approach have serious objections in implementation.