UNIT III

Capital Structure
 Modigliani and Miller (MM)
Approach
The M&M Theorem/Modigliani-Miller Theorem, was developed by
economists Franco Modigliani and Merton Miller in 1958. The main idea
of the M&M theory is that the capital structure of a company does not
affect its overall value.

M&M hypothesis is identical with 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.
 (a) In the absence of taxes. (Theory of
Irrelevance)
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 arbitrage process.

In case two identical firms except for their capital structure have different
market values or cost of capital, arbitrage will take place and the two firms
to have the same total value.
The total value of the homogeneous firms which differ only in respect
of leverage cannot be different because of the operation of arbitrage.
The investors of the firm whose value is higher will sell their shares
and instead buy the shares of the firm whose value is lower.
Investors will be able to earn the same return at lower outlay with
the same perceived risk or lower risk. They would, therefore, be
better off.
The behaviour of the investors will have the effect of (i) increasing
the share prices (value) of the firm whose shares are being
purchased; and (ii) lowering the share prices (value) of the firm
whose shares are being sold. This will continue till the market prices
of the two identical firms become identical. Thus, the switching
operation (arbitrage) drives the total value of two
Assumptions of M&M Approach
1) There are no corporate taxes.
2) There is a prefect market.
3) Investors act rationally.
4) The expected earnings of all the firms have identical risk
characteristics.
5) All earnings are distributed to the shareholders.
6) Risk of investors depends upon the random fluctuations of expected
earnings.
7) Investors can borrow without restrictions and can borrow funds at
same rate of interest
8) Only two source of finance: debt and equity and debt is less risky
 Example
Assume there are two firms, L and U, which are identical in all respects
except that firm L has 10 per cent, Rs 5,00,000 debentures. The earnings
before interest and taxes (EBIT) of both the firms are equal, that is, Rs
1,00,000. The equity-capitalisation rate (ke) of firm L is higher (16 per cent)
than that of firm U (12.5 per cent).

Total market value of the firm which employs debt in the capital structure (L) is more than
that of the unlevered firm (U). Outcome : arbitrage process,
Suppose an investor, Mr X, holds 10 per cent of the outstanding shares of the levered
firm (L). His holdings amount to Rs 31,250 (i.e. 0.10 X Rs 3,12,500) and his share in the
earnings that belong to the equity shareholders would be Rs 5,000 (0.10 X Rs 50,000).
He will sell his holdings in firm L and invest in the unlevered firm (U). Since firm U has
no debt in its capital structure, the financial risk to Mr X would be less than in firm L.
To reach the level of financial risk of firm L, he will borrow additional funds equal to his
proportionate share in the levered firm’s debt on his personal account.
That is, he will substitute personal leverage (or homemade leverage) for corporate
leverage. In other words, instead of the firm using debt, Mr X will borrow money.
Mr X in our example will borrow Rs 50,000 at 10 per cent rate of interest. Out of the
income of Rs 10,000 from the unlevered firm (U), Mr X will pay Rs 5,000 as interest on
his personal borrowings. He will be left with Rs 5,000 that is, the same amount as he
was getting from the levered firm (L).
But his investment outlay in firm U is less (Rs 30,000) as compared with that in firm L
(Rs 31,250).
It is, thus, clear that Mr X will be better off by selling his securities in the
levered firm and buying the shares of the unlevered firm. Other investors
will also, given the assumption of rational investors, enter into the arbitrage
process. The consequent increasing demand for the securities of the
unlevered firm will lead to an increase in the market price of its shares. At
the same time, the price of the shares of the levered firm will decline.
 CRITICISM OF MM APPROACH
(WITHOUT TAXES)
• It is not possible to borrow funds on the same terms and
conditions as corporate can
• Personal leverage is not substitute for corporate
leverage
• Existence of transaction costs
• Institutional Restrictions
• Asymmetric Information
• Existence of corporate tax
 (b) When the corporate taxes are
assumed to exist (Theory of Relevance)

Modigliani and Miller, in their article of 1963 have recognized

that the value of the firm will increase or the cost of capital
will decrease with the use of debt on account of deductibility
of interest charges for tax purpose. Thus, the optimum capital
structure can be achieved by maximizing the debt mix in the
equity of a firm.
 Contd….
Value of levered and unlevered firm under the MM model (assuming
that corporate taxes exist) has been shown in the following figure.
 Illustration

There are two firms X and Y which are exactly identical except that X
does not use any debt in its financing, while Y has Rs. 1,00,000 5%
Debentures in its financing. Both the firms have earnings before
interest and tax of Rs. 25,000 and the equity capitalization rate is 10%.
Assuming the corporation tax of 50% calculate the value of the firm
using M & M approach.
Solution
 Criticism of MM’s Hypothesis
with Corporate Taxes
It is proposed by MM in the presence of corporate taxes that the value
of firm increases with increase in leverage.

Thus, it can be said that a firm can increase its value by increasing its
leverage and maximize it by employing 100% debt in capital. But, this
proposition is criticized for its practical application.

That is in practice, firms do not employ very high levels of debt and
lenders also do not lend the money beyond a limit.
 Contd….
Therefore, the debt portion never becomes 100% but firms choose an
optimum level of debt. The reasons for this are:-

•As the debt increases, the savings of corporate taxes also increases and
at the same time the amount of personal taxes to be paid also increases.
Thus, the liability of personal taxes offsets the advantage of corporate
taxes.

•Greater amount of debt also increases financial risk of the firm. Thus,
the cost of financial distress also increases which again offsets the
advantage of corporate tax savings.
• There are two firms ‘A’ and ‘B’ which are exactly
identical except that A does not use any debt in its
financing, while B has Rs. 2,50,000 , 6% Debentures
in its financing. Both the firms have earnings before
interest and tax of Rs. 75,000 and the equity
capitalization rate is 10%. Assuming the corporation
tax is 50%, calculate the value of the firm
Solution
Problem