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Modigliani Millar Approach

capital structure Assignment / Homework Help
Modigliani Millar approach, popularly known as the MM approach is similar to the Net operating income approach. The MM approach favors the Net operating income approach and agrees with the fact that the cost of capital is independent of the degree of leverage and at any mix of debt-equity proportions. The significance of this MM approach is that it provides operational or behavioral justification for constant cost of capital at any degree of leverage. Whereas, the net operating income approach does not provide operational justification for independence of the company's cost of capital.

Basic Propositions of MM approach:

  • At any degree of leverage, the company's overall cost of capital (ko) and the Value of the firm (V) remains constant. This means that it is independent of the capital structure. The total value can be obtained by capitalizing the operating earnings stream that is expected in future, discounted at an appropriate discount rate suitable for the risk undertaken.

  • The cost of capital (ke) equals the capitalization rate of a pure equity stream and a premium for financial risk. This is equal to the difference between the pure equity capitalization rate and ki times the debt-equity ratio.

  • The minimum cut-off rate for the purpose of capital investments is fully independent of the way in which a project is financed.

Assumptions of MM approach:

  • Capital markets are perfect.

  • All investors have the same expectation of the company's net operating income for the purpose of evaluating the value of the firm.

  • Within similar operating environments, the business risk is equal among all firms.

  • 100% dividend payout ratio.

  • An assumption of "no taxes" was there earlier, which has been removed.

Arbitrage process

Arbitrage process is the operational justification for the Modigliani-Miller hypothesis. Arbitrage is the process of purchasing a security in a market where the price is low and selling it in a market where the price is higher. This results in restoration of equilibrium in the market price of a security asset. This process is a balancing operation which implies that a security cannot sell at different prices. The MM hypothesis states that the total value of homogeneous firms that differ only in leverage will not be different due to the arbitrage operation. Generally, investors will buy the shares of the firm that's price is lower and sell the shares of the firm that's price is higher. This process or this behavior of the investors will have the effect of increasing the price of the shares that is being purchased and decreasing the price of the shares that is being sold. This process will continue till the market prices of these two firms become equal or identical. Thus the arbitrage process drives the value of two homogeneous companies to equality that differs only in leverage.

Limitations of MM hypothesis:

  • Investors would find the personal leverage inconvenient.

  • The risk perception of corporate and personal leverage may be different.

  • Arbitrage process cannot be smooth due the institutional restrictions.

  • Arbitrage process would also be affected by the transaction costs.

  • The corporate leverage and personal leverage are not perfect substitutes.

  • Corporate taxes do exist. However, the assumption of "no taxes" has been removed later.

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