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The document outlines the Modigliani and Miller (M&M) approach to financial decision-making, focusing on capital structure and its impact on a firm's value. It discusses key concepts such as the theory of irrelevance, pecking order theory, and capital gearing, along with their assumptions and implications in finance. The content is aimed at enhancing understanding of financial concepts for applications in investment banking, financial planning, and risk management.

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8 views

2.1.5_M-M_Approach_and_Misc_-_Copy[1]

The document outlines the Modigliani and Miller (M&M) approach to financial decision-making, focusing on capital structure and its impact on a firm's value. It discusses key concepts such as the theory of irrelevance, pecking order theory, and capital gearing, along with their assumptions and implications in finance. The content is aimed at enhancing understanding of financial concepts for applications in investment banking, financial planning, and risk management.

Uploaded by

neelongarry091
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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You are on page 1/ 18

Modigliani and Miller Approach Approach

Course Objectives

. To have an understanding of important financial


concepts and analytical tools used in the financial
decision-making process

Covered Course Outcome

Co Title Level
No

To analyze various sources of capital and


CO3 dividend policies and their structure on the Application
basis of the cost of capital.
2
Learning
Outcomes

1. What does Modigliani and Miller’s


Approach State?
2. Key Assumptions
3. Diagrammatic Explanation
4 Pecking Order Theory
5. Risk-Return Trade-Off
6. Capital Gearing
1. What does Modigliani and Miller Approach States….

The M&M hypothesis is identical to the Net


Operating Income approach if taxes are ignored.
However, when corporate taxes are assumed to exist,
their hypothesis is similar to the Net Income
Approach.
Theory of Irrelevance

In the absence of taxes (Theory of Irrelevance)


The theory proves that the cost of capital is not
affected by changes in the capital structure or says
that the debt–equity mix is irrelevant in the
determination of the total value of a firm. The reason
argued is that though debt is cheaper than equity, with
increased use of debt as a source of finance, the
cost of equity increases.
• This increase in the cost of equity offsets the advantage of
the low cost of debt. Thus, although financial leverage
affects the cost of equity, the overall cost of capital remains
constant. The theory emphasizes the fact that a firm’s
operating income is a determinant of its total value.
• The theory further propounds that beyond a certain limit of
debt, the cost of debt increases (due to increased financial
risk) but the cost of equity falls thereby again balancing the
two costs. In the opinion of Modigliani& Miller, two
identical firms in all respects except their capital structure
cannot have different market values or cost of capital
because of the arbitrage process.
2.Key Assumptions

(i)There are no corporate taxes.


(ii) There is a perfect market.
(iii) Investors act rationally.
(iv) The expected earnings of all the firms have identical risk
characteristics.
(v) The cut–off point of investing in a firm is the capitalization rate.
(vi) Risk to investors depends upon the random fluctuations of expected
earnings and the possibility that the actual value of the variables may turn out to
be different from their best estimates.
(vii) All earnings are distributed to the shareholders.
3. Diagrammatic Depiction

MM approach in the absence of corporate taxes, i.e the theory of irrelevance of


financing mix has been presented in the following figure.

KE (COST OF EQUITY)
COST OF CAPITAL%

K0 (OVERALL
COST OF CAPITAL)

KD (COST OF DEBT)

O X
DEGREE OF LEVERAGE

(MM Theory of Irrelevance : Effect of Leverage on cost of debt, equity and overall cost of capital)
WHEN THE CORPORATE TAXES ARE ASSUMED TO
EXIST (THEORY OF RELEVANCE)
Diagrammatical Explanation

Value of levered and unlevered firm under the MM model (assuming that corporate
taxes exist) has been shown in the following figure.
VL (VALUE OF
LEVERED FIRM)

VALUE OF INTEREST TAX SHIELD


VU (VALUE OF
UNLEVERED FIRM)

O X
DEGREE OF LEVERAGE
A company is having EBIT of Rs 100000.
It expects a return on its investment of 12.5%.
Calculate the value of the firm as per Miller-Modigliani Theory.
4. Pecking Order Theory

The Pecking Order Theory was first suggested by Donaldson in 1961 and it was
modified by Myers in 1984 (Modified Pecking Order Theory). According to
Donaldson’s theory, a firm has well-defined order of preference for raising finance.
Whenever a firm needs funds, it will rely as much as possible on internally generated
funds.
If the internally generated funds are not sufficient to meet the financial requirements, it
will move to debt in the form of term loans and then to non-convertible bonds and
debentures, and then to convertible debt instruments, and then to quasi-equity
instruments and after exhausting all other sources, it may finally move to raise finance
through issue of new equity share capital. This order of preference is so defined
because the internally generated funds have no issue cost and the cost of new equity
issue is the highest.
Key Assumptions
 Raising debt is a cheaper source of finance as compared
to the issue of new equity capital.
 Raising of debt through term loans is relatively cheaper
than issuing bonds or debentures.
 Issue of new equity capital involves heavy issue costs.
 Servicing of debt capital is relatively less as compared to
servicing of equity capital.
 The cost of using internally generated funds is the lowest
because it has no issue cost.
5. Concept of Capital Gearing

• The term ‘capital gearing’ refers to the relationship between equity capital (equity
shares plus reserves) and long–term debt. It may be planned or historical, the
latter describing a state of affairs where the capital structure has evolved over a
period of time, but not necessarily in the most advantageous way.
• In simple words, capital gearing means the ratio between the various types of
securities in the capital structure of the company. A company is said to be in high–
gear, when it has a proportionately higher/large issue of debentures and
preference shares for raising the long–term resources, whereas low–gear stands
for a proportionately large issue of equity shares.
6. Risk Return Tradeoff
Application

• The concepts discussed in this unit will help in the


following:-
• Field of Investment Banking
• Personal Financial Planning
• Area of Budgetary Control
• In the area of Risk Management by doing credit analyssis
Reference Material

Reference Material

Books

1. Chandra, Prasanna “Financial Management”, Tata McGraw Hill, New Delhi

2. Khan M.Y. & Jain P.K, Financial Management, Tata McGraw Hill, New Delhi

3. Pandey I.M “Financial Management”, Vikas Publishing House, New Delhi

4. Shashi, K. Gupta “Financial Management”, Kalyani Publishers.

Weblinks

1. https://byjus.com/commerce/capital-structure/

2. https://www.investopedia.com/terms/c/capitalstructure.asp

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