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In the corporate world, awareness about your firm’s market value to
precision is perhaps the stepping stone for operating a successful
business. An accurate business assessment can be helpful at times of
mergers or acquisitions but even more so while developing
investment strategies for the firm and maximizing its profits. And there is no doubt calculating a firm’s value is a cumbersome and complicated task. Prior financial knowledge is necessary and there
are so many factors to be considered.
Many theories for the valuation of businesses have been put forward
and one of them is the Modigliani & Miller theory devised by Franco
Modigliani and Merton Miller in the 1950s. Their work was published
in the American Economic Review under ‘ The cost of capital,
corporation finance and the theory of investment ‘.

The theory comprises of mainly two propositions and also takes into account several assumptions. It states that the valuation of a firm is
independent of its capital structure, that is the market
value of a business does not depend on how the firm finances its
assets. It may finance assets through debt (borrowing) or through
equity (securities) but this decision doesn’t affect its valuation.
Rather the valuation is solely dependent on its ability to generate
revenue and profit. Since the theory is oblivious to a firm’s capital structure, it’s also known as capital structure irrelevance theory. The
main assumption in this process is that a firm operates in a world
with no taxes which is practically impossible in any part of this world.
But we move on to study the propositions made by Modigliani and
Miller and understand various prospects of valuation.

Before jumping straight off to the propositions, let us look at the
core assumptions of this model –

  1. There are no taxes taken into consideration during valuation.
  2. The transactional costs (the commissions) and the bankruptcy
    costs ( increased cost of debt due to high risk) are not valid.
  3. There is equality of information i.e. both the investor and
    corporations have access to the same information and thus
    they behave rationally.
  4. There is no corporate dividend tax (CDT).

It states that given there are no taxes, the market value of a
leveraged firm (using debt) is the same as that of an unleveraged
firm (using equity purely). The capital structure simply doesn’t affect
the valuation of the firm. It also suggests that debt holders and
equity shareholders have the same priority i.e. earnings are split
equally among them.
For a better understanding of this proposition, we use an example.
There’s a firm X which is financed solely through equity and has
assets worth ₹ 1,00,000 with 50,000 shares outstanding. The firm
now decides to borrow ₹50,000 as debt and repurchase some
shares. We look at how the valuation is affected by this decision.
CASE 1 – ASSETS = ₹ 1,00,000
DEBT = 0
EQUITY VALUE = ₹ 1,00,000 ( from 50,000 shares)
Share price = ₹1 ,00,000/50,000 =₹ 2/share

CASE 2 – ASSETS = ₹ 1,00,000
DEBT = ₹ 50,000
EQUITY = ₹ 50,000 ( from 25,000 shares and price = ₹ 2/share )

We see from this illustration that given there are no taxes levied, the
valuation of the firm remains the same irrespective of the mode
the firm uses to finance its operations. Another observation is that
the share price remains constant.

It states that financial leverage is directly proportional to the cost
of equity. With an increase in the debt component of the firm, the equity
shareholders play a high risk by investing. Hence, they expect a
higher return from their investments, thereby increasing the cost of
equity. This proposition assumes that the debt shareholders have an
upper hand as far as the claim on earnings is concerned.
Both these propositions in synergy give us the Modigliani & Miller
theorem. Although the theory states that capital structure doesn’t
affect the valuation of the firm but it also gives out the idea that the
actual cost of debt is less than the nominal cost of debt due to tax
exemptions. This is not the case with dividends paid by companies on
equity. The Modigliani and Miller approach is one of the modern
approaches of Capital structure theory. Modigliani was awarded the
Nobel Prize for economics in 1985 and Miller received the same in 1990 which he shared with two others.

However, practical limitations of this theory draw from a variety of real-world phenomena, first of which is the issue of taxation which the approach assumes away to be zero. Secondly, given the nature of the type of finance a firm draws from debt and equity, bondholders and preferential shareholders of a company are usually the first in line to be paid their money normally as well as in case of bankruptcy and other shareholders come last, unlike the equal treatment the theory implies for share and bondholders. Thirdly, Modigliani and Miller do not accept the net income approach on the fact that two identical firms except for the degree of leverage, have different market values. Moreover, since the trade of securities involves costs so a financially more leveraged firm has a higher market value; and this fact is disregarded in the theory.

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