Question

For which of these firms would Modigliani-Miller do the best job of explaining their capital structure choices?

  

A firm that only invests in very long term investments

   

A firm in financial distress

   

A firm whose choice of projects is heavily influenced by the financing options available to them

   

A firm whose shares are very inconvenient to buy or sell

Answer 1

A firm whose shares are very inconvenient to buy or sell

Reason :

The Modigliani-Miller theorem (M&M) states that the market value of a company is correctly calculated as the present value of its future earnings and its underlying assets, and is independent of its capital structure.

At its most basic level, the theorem argues that, with certain assumptions in place, it is irrelevant whether a company finances its growth by borrowing, by issuing stock shares, or by reinvesting its profits.

Companies have only three ways to raise money to finance their operations and fuel their growth and expansion. They can borrow money by issuing bonds or obtaining loans; they can re-invest their profits in their operations, or they can issue new stock shares to investors.

Modigliani-Miller Theorem

The Modigliani-Miller theorem argues that the option or combination of options that a company chooses has no effect on its real market value.

Merton Miller, one of the two originators of the theorem, explains the concept behind the theory with an analogy in his book, Financial Innovations and Market Volatility:

"Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as is. Or he can separate out the cream and sell it at a considerably higher price than the whole milk would bring. (That's the analog of a firm selling low-yield and hence high-priced debt securities.) But, of course, what the farmer would have left would be skim milk with low butterfat content and that would sell for much less than whole milk. That corresponds to the levered equity. The M and M proposition says that if there were no costs of separation (and, of course, no government dairy-support programs), the cream plus the skim milk would bring the same price as the whole milk."