Modigliani and Miller Approach
Modigliani and Millar (MM) hypothesis states that capital structure is irrelevant for the valuation of a firm. It implies that by changing the proportion of debt and equity, the value of a firm does not change. Firm’s value depends on its earnings and risk of its assets rather than financial leverage (debt-equity ratio).
There are two main propositions under MM Hypothesis-
Proposition 1: Cost of capital is independent of the capital structure of a firm. Hence capital structure is irrelevant for firm’s valuation.
Proposition II : Cost of equity increases proportionately with increase in the proportion of debt so as to nullify the benefit of cheaper debt. Cost of equity is calculated as follows
Ke = K0 + (K0 – Kd) D/E
MM Hypothesis is based on the following assumptions:
(1) Perfect Capital Markets: Capital markets are perfect. All investors are rational. Investors can freely buy or sell securities. There are no transaction costs and securities are infinitely divisible.
(2) Homemade Leverage ( or personal leverage) is a perfect substitute for corporate leverage: It implies that investors can borrow unlimited amount at the same interest rate as the companies can.
(3) No Taxes: There are no corporate taxes. Thus, there is no tax saving for firms on interest payment of debt.
(4) Full Payout: Firms distribute all their earnings after interest as dividends. Thus, the dividend payout ratio is 100%.
Given the above assumptions two firms belonging to same risk class ( i.e. having same operating risk), must have same value irrespective of their capital structure.
This happens due to ARBITRAGE PROCESS.