Question

The capital structure irrelevance theory proposed by Modigliani and Miller (MM) is often criticized to be based on very restrictive assumptions which are unrealistic in the world today. However, the theory is still considered extremely important. (word limit 400)

a. Why it is important?

b. Illustrate three main assumptions made by MM and discuss how the problems are tackled by alternative capital structure theories.

Answer 1

1. The Modigilani and Miller theory of capital structure is one of the most important theories of capital structure. It has acted as a base for many theories and has helped the revolution of corporate finance. The first theory was created for an ideal environment and perfectly efficient markets, only partially real . The theorem stated that market value of two identical firms will remain the same irrespective of their capital structure, if they have the same business risk. But the second theory was more efficient for the actual world as it involved payment of taxes and its impact on the interest payment. Modigilani-Miller theorem helps to understand the factors most important in the relationship between the capital structure of the firm and the value of the firm.

b. The assumptions of this theory are as under:

1. No transaction cost: there is no transaction cost of buying and selling any securities, stock or any investments made. There are no fees or commission paid while issuing shares or bonds.
   But i reality while buying securities there is some cost required in the form of brokerage and commission for which will increase the cost of the share.
2. Equal borrowing cost: This means that the companies and investors will borrow at the same cost . This states that whether it is a company borrowing money or a investor and buying the companies share, the cost of borrowing will remain the same.
   But If even the company or the investor can borrow the at different rates, the theorem will not hold up. as such, the cost of borrowing of individual if higher than that of companies.
3. Handling of excess cash : one of the other main assumption of this theory is that if the firm has excess cash at disposal they will not waste it in any foolish investment or unnecessary expenses but will invest it into a greater opportunity that will help the firm to earn high returns than keeping the money with them. They will wait for best investment opportunities to invest it.
   but in reality the firm does go for wasting the frees cash earned on either wrong investment or in wasting it on unnecessary investments.