COLLEGE OF TECHNOLOGY LONDON

Corporate Finance
Course code: MBA3110-L

ASSESSMENT: 1

Topic:
Modigilani and Miller theorem

Student name : Varsha Muchintala

Student id : 096329-88
UWL id : 29002026
Lecturer : Piotr konwicki
Total words : 1500
Due date of submission : 23, August, 2010
INTRODUCTION:

Modigilani and Miller (1958) proposed the theorem on capital structure which is also
called as capital structure irrelevance theory. The theory states that value of the firm in a
perfect ca market capital structure is unaffected by how it is financed whether it is by issuing
stock or selling debt and the dividend policy by assumptions of no taxes, transaction costs,
bankruptcy costs, Agency costs. Two propositions are taken to prove the theorem without
taxes of an unlevered firm and levered firm with taxes. Modigilani and miller theorem states
that value of the two firms with taxes and without taxes are same. Miller (1991) to an
interview to a channel in general explained to common people about capital structure
irrelevancy theorem as assuming firm as a “gigantic tub of whole milk and the farmer can sell
the whole milk as it is or he can separate the cream from the milk and sell the cream as
considerably higher price than whole milk”, (qfinance.com). Modigilani and miller says if
there was no cost in separation of cream and milk , then cost of cream and skimmed milk is
same as whole milk.
Modigilani and miller (1958) proposed the theorem by assuming perfect market that is with
no arbitrages and by assumption of taxes, transaction costs, agency costs, bankruptcy costs as
the zero values, so they do not affect the value of the firm. In real market world taxes are the
most important for the firms to pay for the government on the income of the firm. Williamson
(1985) Transaction costs of the firm in real market world market they are considered as the
transaction costs depends on setting up and running the capital structure and also for
governing the financial resources. Jensen and meckling (1976) introduced Agency costs
which are given importance because they deal with cash flows of the firms and which
influence the financial value of the capital structure. Titman (1984), Bankruptcy costs are the
risks associated with every firms as every firm has debts, the increasing of debts may leads to
risks of bankruptcy costs. Modigilani and miller (1963) revised the capital structure theorem
with the imperfections of corporate taxes and firms without taxes and stated that value of the
two firms is same.

DISCUSSION:

Modigilani and miller capital structure theory started by assuming the firm has particular cash
flows of debt and equity. The cash flows of the debt and equity of the firm are chosen for
financial assets, and then the proportions of the cash flows of the firm are divided equally
among the investors. Investors and the firm have equal access to financial markets thus it is a
homemade leverage. Leverage of the firm can be created by the investors of the firm, and
they can get rid of any leverage of the firm. As a result the leverage of the firm does not have
effect on the market value of the firm. Different firms choose different capital structures
according to their capital so unable to satisfy all conditions in perfect market so imperfections
became more important in real market world (Miller, 1989, p-6-18). The main imperfections
of Modigilani and miller theorem are taxes, transaction costs, bankruptcy costs, and the
agency costs.
Taxes are the major imperfections of Modigilani and miller theorem. Miller (1963) theorem
revised capital structure is with corporation taxes and they argued as the value of the firms
with taxes and without taxes are same. The dividends of the firms which is making higher
rate than that of capital gains, and the firms that are making smaller dividend payments
should trade at premium level. Miller (1963) argues that corporate income taxes of firms’
capital structure should be 100 percent of the firm. Farrar & Selwyn (1967) argues that higher
taxes on personal income than on capital gains of the firm so, that optimal structure of capital
can be followed and the firms should maintain dividend zero policy. Black and Scholes
(1974) deals with payments of positive dividends and they did not find any significant
relationship between stock price and dividends and thus supported irrelevancy theory.
High dividend may increase the firm value and it has positive impact on share price (odegen,
1994). The other authors’ loughlin (1989) argue that in real world with taxes where high
dividends may bring high taxes and reduce the firm value and decrease share price. Some of
the criticisms of miller irrelevancy theorem about taxes are, in real world market taxes are
necessary and liable to pay on the capital gain income and on the personal income. To pay
less tax the firms show less dividends then if it more low then the problem arises and may
increases to high probability of bankruptcy and it automatically affects the firm value. In
Modigilani and miller theorem some of the relevance things regarding taxes are, in the
absence of taxes there is no increase of leverage or the benefits in creation of value.

Transaction costs are the imperfections of perfect market Modigilani and miller capital
structure proposition. Transaction costs are the governance of contract relations each other
the firm and the other party (hennart, 1993), and the transaction cost are at different levels in
different capital structures. Transaction costs does not depend upon the prices of goods or
services exchanged (Robins, 1987). Transaction costs are related to the firms of the potential
suppliers of the finance who has contract and benefit to the firm and recourse available to
them (Williamson, 1988). Benefits represent to the property of the streams generated on
returns of assets. Recourse represents to the rights over managerial actions. The debt
instrument of the firm possesses benefits and the interest payments of the contract time. Debt
holders of the firm have control of managerial actions through contract to know whether the
resources of the firm are utilized efficiently or not.
In the perfect market transaction costs are assumed as zero, when Modigilani and miller
introduced corporate taxes to the firm while introducing capital structure to the firm funding
of assets are necessary to the market value of the firm then management training at
maximising shareholders wealth will be no longer remained how the firm value is financed.
Debt capacity of a firm is limited. High debt leverage may increase the bankruptcy cost and
may lead to negative impact on the market value of the firm. When the debt of the firm
increases beyond the capital limits so, the firm may be unable to repay the payments and thus
bankruptcy occurs (terje et.al, 2006). Although sebnet (1974) argues that bankruptcy costs are
indeterminate of capital structure firm value.
Agency costs are the costs that occur in between shareholders and the managers of the firm
due to some core problems. Shareholders expect the managers to run the company as to
increase the share value of the company. Managers of the firm think to run the company to
increase their personal power and wealth that may not be interests of share holders. cash
flows are there in every firm, In a higher firm there will be more cash flows and holds too
much of cash, so to monitor the managers of the firms and to invest in capital making
decisions with low risk and expecting higher returns from the capital, so in making
investments cash flow is necessary. So dividends influence the financial firms (Easter brooks
et.al, 1984). Inefficient use of excessive cash from higher than normal leverage would
increase the agency costs (Jensen, 1986). To measure the performance of a firm and the
volatility of agency costs stock market returns are used (Saunders et al, 1990).
According to Groth (1997), Imperfections may result in the capital structure less than the
optimum. Choosing of the capital structure is based on managers’ decision and they generally
prefer the capital structure with high firm value and which increases the interests in
shareholders.
CONCLUSION:

In perfect market capital structure irrelevancy theorem, cost of assumptions is zero and they
do not vary independently, so there is zero gain from any of them, so the value of the firm is
not effected though how they are chosen. Depending upon the assumptions various capital
structures are designed according to their interests because all the assumptions affect the
financial leverage of the firm.
Modigilani and miller theorem is one of the revolutionary theories in corporate finance of
finding capital structure, basically helps for the future development and modernisation of the
theory and also it is the first theory which encourages in improving the capital structure value
in the modern world. Though in practical, none of the assumptions are met in the real world.
By applying theorem and determinants of the equations many capital structures are developed
based on the irrelevancy theory by solving determinants and many capital structures are
developed such as trade off theory and pecking order theory. Modigilani and miller
irrelevancy theorem explained the importance of capital structure of a firm.

REFERENCES:

1. Modigilani, F.F and M.H.Miller (1958). The cost of capital, Corporate Finance, and
the theory of investment, American Economic Review, vol. 48, No.3.

2. Modigilani F&M Miller, (1963).Corporate income taxes and cost of capital: A

correction, American Economic review, vol.53.

3. Miller, M.H (1989). ‘The Modigilani-miller propositions after thirty years’,

journal of applied corporate finance, 2(T) pp.6-18.

4. Jensen, M.C; (1986), Agency costs of free cash flow, Corporate Finance and
takeovers, American Economic Review, 76, pp 323-339.

5. Titman, S.; (1984), the effect of capital structure on a firms liquidation decision
Journal of financial Economics, 13, pp.37-151.

6. Rahul kachhar, (1996), Explaining Firm capital structure: The role of Agency theory
Vs Transaction cost Economic, Strategic management of journal, vol.17, pp.713-728
accessed online (19.08.2010) http://www.jstor.org/stable/248672

7. Robert A haugen, Lemma W.senbet, (1978), the insignificance of Bankruptcy costs to the
theory of optimal capital structure, the journal of finance, vol.33, No.2, pp. 383-393.
Accessed online (15.08.2010) http://www.jstor.org/stable/2326557

8. Harold Kent Baker (2009), Dividends and Dividend policy, published by john Wiley and sons,
pp.100-120.
9. www.qfinance.com