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MODIGLIANI AND MILLER CAPITAL STRUCTURE APPROACH

Modiglianiand Miller, two profeor in t!e "#$%, t&died 'apital(

tr&'t&re t!eor) intenel)* +ro t!eir anal)i, t!e) de-eloped t!e

'apital(tr&'t&re irrele-an'e propoition* Eentiall), t!e)

!)pot!ei.ed t!at in perfe't ar/et, it doe not atter w!at 'apital

tr&'t&re a 'opan) &e to finan'e it operation* T!e) t!eori.ed

t!at t!e ar/et -al&e of a fir i deterined 0) it earning power and

0) t!e ri/ of it &nderl)ing aet, and t!at it -al&e i independent

of t!e wa) it '!ooe to finan'e it in-etent or ditri0&te

di-idend*

T!e 0ai' M1M propoition i 0aed on t!e following /e) a&ption2

No ta3e

No trana'tion 'ot

No 0an/r&pt') 'ot

E4&i-alen'e in 0orrowing 'ot for 0ot! 'opanie and in-etor

S)etr) of ar/et inforation, eaning 'opanie and

in-etor !a-e t!e ae inforation

No effe't of de0t on a 'opan)5 earning 0efore interet and

ta3e

Of 'o&re, in t!e real world, t!ere are ta3e, trana'tion 'ot,

0an/r&pt') 'ot, differen'e in 0orrowing 'ot, inforation

a)etrie and effe't of de0t on earning* To &ndertand !ow t!e

M1M propoition wor/ after fa'toring in 'orporate ta3e, !owe-er,

we &t firt &ndertand t!e 0ai' of M1M propoition I and II

wit!o&t ta3e*

odigliani and iller5 Capital(Str&'t&re Irrele-an'e Propoition

T!e M1M 'apital(tr&'t&re irrele-an'e propoition a&e no ta3e

and no 0an/r&pt') 'ot* In t!i iplified -iew, t!e weig!ted a-erage

'ot of 'apital 67ACC8 !o&ld reain 'ontant wit! '!ange in t!e

http://www.investopedia.com/terms/f/franco-modigliani.asphttp://www.investopedia.com/terms/m/merton-miller.asphttp://www.investopedia.com/terms/m/merton-miller.asphttp://www.investopedia.com/terms/f/franco-modigliani.asp

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'opan)5 'apital tr&'t&re* +or e3aple, no atter !ow t!e fir

0orrow, t!ere will 0e no ta3 0enefit fro interet pa)ent and t!&

no '!ange or 0enefit to t!e 7ACC* Additionall), in'e t!ere are no

'!ange or 0enefit fro in'reae in de0t, t!e 'apital tr&'t&re doe

not infl&en'e a 'opan)5 to'/ pri'e, and t!e 'apital tr&'t&re it!erefore irrele-ant to a 'opan)5 to'/ pri'e*

Howe-er, a we !a-e tated, ta3e and 0an/r&pt') 'ot do

ignifi'antl) affe't a 'opan)5 to'/ pri'e* In additional paper,

Modigliani and Miller in'l&ded 0ot! t!e effe't of ta3e and 0an/r&pt')

'ot*

odigliani and iller5 Tradeoff T!eor) of Le-erage

T!e tradeoff t!eor) a&e t!at t!ere are 0enefit to le-erage wit!in

a 'apital tr&'t&re &p &ntil t!e optial 'apital tr&'t&re i rea'!ed*

T!e t!eor) re'ogni.e t!e ta3 0enefit fro interet pa)ent ( t!at i,

0e'a&e interet paid on de0t i ta3 ded&'ti0le, i&ing 0ond

effe'ti-el) red&'e a 'opan)5 ta3 lia0ilit)* Pa)ing di-idend on

e4&it), !owe-er, doe not* T!o&g!t of anot!er wa), t!e a't&al rate of

interet 'opanie pa) on t!e 0ond t!e) i&e i le t!an t!e

noinal rate of interet 0e'a&e of t!e ta3 a-ing* St&die &gget,

!owe-er, t!at ot 'opanie !a-e le le-erage t!an t!i t!eor)

wo&ld &gget i optial*

In 'oparing t!e two t!eorie, t!e ain differen'e 0etween t!e i

t!e potential 0enefit fro de0t in a 'apital tr&'t&re, w!i'! 'oe

fro t!e ta3 0enefit of t!e interet pa)ent* Sin'e t!e MM 'apital(

tr&'t&re irrele-an'e t!eor) a&e no ta3e, t!i 0enefit i not

re'ogni.ed, &nli/e t!e tradeoff t!eor) of le-erage, w!ere ta3e, and

t!& t!e ta3 0enefit of interet pa)ent, are re'ogni.ed*

In &ar), t!e MM I t!eor) wit!o&t 'orporate ta3e a) t!at a

fir5 relati-e proportion of de0t and e4&it) don5t atter9 MM I wit!

'orporate ta3e a) t!at t!e fir wit! t!e greater proportion of de0t

i ore -al&a0le 0e'a&e of t!e interet ta3 !ield*

MM II deal wit! t!e 7ACC* It a) t!at a t!e proportion of de0t in

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t!e 'opan)5 'apital tr&'t&re in'reae, it ret&rn on e4&it) to

!are!older in'reae in a linear fa!ion* T!e e3iten'e of !ig!er

de0t le-el a/e in-eting in t!e 'opan) ore ri/), o

!are!older deand a !ig!er ri/ prei& on t!e 'opan)5 to'/*

Howe-er, 0e'a&e t!e 'opan)5 'apital tr&'t&re i irrele-ant,'!ange in t!e de0t(e4&it) ratio do not affe't 7ACC* MM II wit!

'orporate ta3e a'/nowledge t!e 'orporate ta3 a-ing fro t!e

interet ta3 ded&'tion and t!& 'on'l&de t!at '!ange in t!e de0t(

e4&it) ratio do affe't 7ACC* T!erefore, a greater proportion of de0t

lower t!e 'opan)5 7ACC*

Modigliani and Miller Approa'! indi'ate t!at -al&e of a le-eraged fir

6fir w!i'! !a a i3 of de0t and e4&it)8 i t!e ae a t!e -al&e of

an &nle-eraged fir 6fir w!i'! i w!oll) finan'ed 0) e4&it)8 if t!e

operating profit and f&t&re prope't are ae* T!at i, if an in-etor

p&r'!ae !are of a le-eraged fir, it wo&ld 'ot !i t!e ae a

0&)ing t!e !are of an &nle-eraged fir*

odigliani and iller Approa'!2 Two Propoition wit!o&t Ta3e

Propoition "2 7it! t!e a0o-e a&ption of :no ta3e;, t!e 'apital

tr&'t&re doe not infl&en'e t!e -al&ation of a fir* In ot!er word,

le-eraging t!e 'opan) doe not in'reae t!e ar/et -al&e of t!e

'opan)* It alo &gget t!at de0t !older in t!e 'opan) and e4&it)

!are !older !a-e t!e ae priorit) i*e* earning are plit e4&all)

aongt t!e*

Propoition

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odigliani and iller Approa'!2 Propoition wit! Ta3e 6T!e

Trade(Off T!eor) of Le-erage8

T!e Modigliani and Miller Approa'! a&e t!at t!ere are no ta3e*

=&t in real world, t!i i far fro tr&t!* Mot 'o&ntrie, if not all, ta3 a

'opan)* T!i t!eor) re'ogni.e t!e ta3 0enefit a''r&ed 0) interet

pa)ent* T!e interet paid on 0orrowed f&nd i ta3 ded&'ti0le*

Howe-er, t!e ae i not t!e 'ae wit! di-idend paid on e4&it)* To

p&t it in ot!er word, t!e a't&al 'ot of de0t i le t!an t!e noinal

'ot of de0t 0e'a&e of ta3 0enefit* T!e trade(off t!eor) ad-o'ate

t!at a 'opan) 'an 'apitali.e it re4&ireent wit! de0t a long a

t!e 'ot of ditre i*e* t!e 'ot of 0an/r&pt') e3'eed t!e -al&e of

ta3 0enefit* T!&, t!e in'reaed de0t, &ntil a gi-en t!re!old -al&e

will add -al&e to a 'opan)*

T!i approa'! wit! 'orporate ta3e doe a'/nowledge ta3 a-ing

and t!& infer t!at a '!ange in de0t e4&it) ratio !a an effe't on

7ACC 67eig!ted A-erage Cot of Capital8* T!i ean !ig!er t!e de0t,

lower i t!e 7ACC* T!i Modigilani and Miller approa'! i one of t!e

odern approa'!e of Capital Str&'t&re T!eor)*

Ar0itrage pro'e

Ar0itrage pro'e i t!e operational >&tifi'ation for t!e

Modigliani(Miller !)pot!ei* Ar0itrage i t!e pro'e of p&r'!aing a

e'&rit) in a ar/et w!ere t!e pri'e i low and elling it in a ar/et

w!ere t!e pri'e i !ig!er* T!i re&lt in retoration of e4&ili0ri& in

t!e ar/et pri'e of a e'&rit) aet* T!i pro'e i a 0alan'ing

operation w!i'! iplie t!at a e'&rit) 'annot ell at different pri'e*

T!e MM !)pot!ei tate t!at t!e total -al&e of !oogeneo& fir

t!at differ onl) in le-erage will not 0e different d&e to t!e ar0itrageoperation* Generall), in-etor will 0&) t!e !are of t!e fir t!at5

pri'e i lower and ell t!e !are of t!e fir t!at5 pri'e i !ig!er* T!i

pro'e or t!i 0e!a-ior of t!e in-etor will !a-e t!e effe't of

in'reaing t!e pri'e of t!e !are t!at i 0eing p&r'!aed and

de'reaing t!e pri'e of t!e !are t!at i 0eing old* T!i pro'e will

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'ontin&e till t!e ar/et pri'e of t!ee two fir 0e'oe e4&al or

identi'al* T!& t!e ar0itrage pro'e dri-e t!e -al&e of two

!oogeneo& 'opanie to e4&alit) t!at differ onl) in le-erage*

Liitation of MM !)pot!ei2

"* In-etor wo&ld find t!e peronal le-erage in'on-enient*