Explain and walk through the components of the Modigliani-Miller model. What is the function of the...

Explain and walk through the components of the Modigliani-Miller model. What is the function of the model? What is meant by a perfect market, and how does this model relate? Are there any limitations to the model?

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Modigliani miller approach advocates that the markes value of a firm depends upon earnings of a company and risk associated with its underlying assets and is independent of the way it finances investments or distributes dividends. Different components of Modigliani Miller model are as follows:-

1. Investors are rational.

2. Perfect capital market.

3. There is a zero tax environment.

4. There is no transaction cost.

5. Earnings are prepetual and are constant.

6. Divedend payout ratio is 100 percent.

7. Investors borrow without restrictions and can borrow funds at same rate of interest.

8. Investment decisions are known and constant.

9.Only two source of finance: debt and equity.Equity are constant.

10.There are no cost of financial distress and liquidation.

11.The firm can be classified into distinct homogenous risk classes.

A theoritical market in which buyers and sellers are so numerous and well informed that there are no monopoly and there are a large numbers of aware buyers and sellers and there are no scope for manipulation.This type of market is known as a perfect market. MM Model specifies that there is a perfect competitive market which is free from any kind of price manipulation.With perfect capiital markets,the choice of debt or equity financing will not affect the total value of the firm,it's share price.or its cost of capital.As a result,firms and there stockholders are indifferent to choice of financing.

Functions of MM model is that it is used in valuation of the companies along with giving irrelevance to dividend.It is also used in finding out the capital structure of companies as it does not differentiate between debt and equity.

Limitations of MM's model are as follows -

1.Perfect capital market does not exist.Taxes are present in the capital market.

2.According to this theory,there is no difference between internal and external financing.It is not true because there are floatation costs involved

3.This theory belives that the shareholders wealth is not affected by the dividends but investors always prefer dividend

4.The assumption of uncertainity is not true as there exists a lot of uncertainity

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Explain and walk through the components of the Modigliani-Miller model. What is the function of the...

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