MODIGLIANI – MILLER APPROACH
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MODIGLIANI – MILLER APPROACH THEORY OF CAPITAL STRUCTURE Presented by- TASNEEM TAJ A30601911030 MBA SEM - II FRANCO MODIGLIANI MERTON MILLER
Transcript of MODIGLIANI – MILLER APPROACH
MODIGLIANI – MILLER APPROACH
THEORY OF CAPITAL STRUCTURE
Presented by-
TASNEEM TAJA30601911030
MBA SEM - IIFRANCO MODIGLIANI
MERTON MILLER
IntroductionCapital structure is the proportionate relationship
between debt & equity.
Early theoreticians believed that the average cost of capital decreased with the use of leverage and the value of the firm increased while the value of the equity remained constant.
RisksBusiness riskFinancial risk
Effect of leverage on cost of capital
0.2 0.4 0.6 0.80.00
0.02
0.04
0.06
0.08
0.10
0.12
Kd KO KE
Modigliani – miller theory
In perfect capital markets without taxes & transaction costs, a firm’s market value
& cost of capital remain invariant to the capital
structure changes.
Assumptions
Perfect capital
markets.
Homogeneous risk
classes.
RiskNo
taxes.Full
payout.
Proposition I – no taxFor firms in the same risk class, the total market
value is independent of the debt-equity mix .It is given by capitalizing the expected the net
operating income by the capitalization rate.VU = VL , where
VU = Value of unlevered firm.VL = Value of levered firm.
Arbitrage process.
Proposition iiLevered firm’s cost of capital remains constant
with financial leverage.Cost of equity under M-M approach
Series10.00
0.05
0.10
0.15
0.20
0.25
KDKOKE
LEVERAGE
Example – Cash flows
UNLEVERED (100% Equity)
LEVERED (80% Equity & 20% Debt)
EBIT 1000 1000
(-) Interest (5%) 0 50
EBT 1000 950
(-) Tax 0 0
Net Income 1000 950
With taxPROPOSITION - I PROPOSITION - II
After introduction of corporate tax, the optimal capital structure is 100 % debt.
Proposition II, shows that because interest payments are tax-deductible, the value of a levered firm (VL) increases with debt.
VL = VE + TC * D
exampleUNLEVERED (100% Equity)
LEVERED (80% Equity & 20% Debt)
EBIT 1000 1000
(-) Interest (5%) 0 50
EBT 1000 950
(-) Tax (34%) 340 323
Net Income 660 627
Criticisms
Lending & borrowing rates discrepancy.
Transaction costs.
Institutional restrictions.
Existence of corporate tax.
Non-substitutability of personal & corporate leverage.
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