Question

Answer the question in 300 words.

Describe the assumptions made in the Modigliani and Miller Capital Structure Theory, and their possible limitations.

Answer 1

Modigliani and Miller Capital Structure Theory- This approach was established by Modigliani and Miller in 1950. This theory is a capital structure theory that says, that valuation of firm is irrelevant to the capital structure of a firm. Value of firm does not depend upon heavy or less debt rather it depends upon the operating efficiency and operating income of company. This theory states that in company's capital structure, there is either debt or equity or both, both have advantages and disadvantages. Value of firm does not depend upon choice of the financing alternative rather on operating profit.

It also states that a firm's value is independent of its dividend policy and cash management policy.

Assumptions- Are as following:

1. There is perfect capital market.
2. There is no tax and no transaction cost.
3. There is no bankruptcy cost and no floating cost.
4. Companies and investors have the same information.
5. There is no effect of debt on company's Earning before interest and taxes.
6. Individuals and firms are price takers.

Limitations- Are as following:

1. This scenario is not practical, in practical world, there are taxes, transaction cost, floating cost and bankruptcy cost.
2. There is always uncertainty in the market.
3. Debt affects company's earnings as interest on debt is deducted from EBIT only so earning before tax comes down if amount of interest is large. Heavy amount of interest affect profits of company and heavy debt is an obligation.
4. Company's key people have some confidential and internal information about the company that investors cannot have.