Question

The answer should have some critical thinking and class concepts -(Corporate Financial Management). Do not exceed 650 words. You are allowed to cite websites and have references. Thanks.

In your own words, describe the M&M theory i.e. choose one of the two propositions, include how it benefits/affects the company and/or the shareholders.

Answer 1

M&M theory is also known as irrelevant theory of dividend policy. This policy says:

- Dividend is considered to be irrelevant and it does not affect the firm value.

-Firm value means it does not affect share price

In general terms, there are some expert says that mixture of debt and equity affects the firm value; but, some experts say it does not affect the firm value, whatever the combination (debt+equity)is. So, second type of approach is actually based on MM theory, which is also called Irrelevant theory of Capital Structure.So,

Valuation of firm is irrelevant to the Capital Structure of a company whether a firm is highly leveraged or has a lower debt component, it has no bearing on its market value. Rather the market value of a firm is dependent on the operating profits of the company.

The fundamentals of Modigliani and Miller approach resemble that of Net Operating Income Approach.

Assumptions of MM theory:

1. There are no taxes.

2. Transactions Cost for buying and selling securities as well as bankruptcy cost is nil.

3. There is symmetry bof information that a corporation would and investors would behave rationally.

4. The cost of borrowing is the same for investors as well as companies.

5. There is no floatation cost like underwriting commission, payment to merchant bankers, advertisement expenses etc.

6. There is no corporate dividend tax.

- Modigliani and Miller Approach indicates that value of a leveraged firm is the same as the value of an uneveraged firm if the operating profits and future prospects are same.

After analyzing, expertise got some shortcomings too. It is not possible that there can not be any t corporate taxes in any country. So, again it has been revised.

MM approach- two proposition without taxes

Proposition 1-With the above assumptions of "no taxes", the capital structure does not influence the valuation of a firm. In other words leveraging the company does not increase the market value of the company. It also suggests that debt holders in the company and equity shareholders have the same priority i.e. earnings are split equally amongst them.

Proposition 2- This theory recognizes the tax benefits accrued by interest payments.

- The interest bpaid on borrowed funds is tax deductible.

- The actual cost of debt is less than the nominal cost of debt because of tax benefits.

- The trade off theory advocates that a company can capitalize it's requirements with debts as long as the cost of distress i.e. the cost of bankruptcy exceeds the value of tax benefits. This the increased debts until a given threshold value will add value to a company.

So, if we consider the assumption of tax then this irrelevant theory become relevant.