Mms proposition ii shows that there is no contradic. Modigliani and miller approach mm approach it is a capital structure theory named after franco modigliani and merton miller. The first milestone on the issue was set by modigliani and miller1958 through which they presented in their seminal work two important propositions that shaped the economic theory behind capital structure and its effect on firm value. In their study the cost of capital, corporation finance and the theory of investment 1958 laureates of nobel price nobel franco modigliani and merton miller represent what could possibly be the most important theory for the structure of capital.
The criticism of the modigliani and miller hypothesis finance. Under these assumptions mm theory proved that there is no optimal debt to equity ratio and capital structure is irrelevant for the shareholders. Trade off pdf theory of capital structure primarily deals with the two concepts cost of financial distress and agency costs. Modigliani and millers theorem, capitals structure, firm value, debt, leverage.
Finance scholars approach to capital structure issues reflects a progression of thought over time. The first is substantive and it stems from their nature of irrelevance propositions. This note provides an overview of the current state of capital structure theory. Capital structure wharton finance university of pennsylvania. Static tradeoff theory the horizontal base line in figure 17. Whether a firm is highly leveraged or has a lower debt component has no bearing on its market value. Meaning of capital structure capital structure refers to the combination or mix of debt and equity which a company uses to finance its long term operations. The capital structure puzzle myers 1984 the journal. There has been little if any research testing whether the relationship between financial leverage and investors required return is as the pure mm theory predicts. The theory of capital structure wiley online library.
According to this theory, the total market value of the firm v is not affected by the change in the capital structure and the overall cost of capital ko remains fixed irrespective of the debtequity mix. Modigliani it is the best known and most widely discussed model of the nobel prize receivers in economics franco modigliani and merton howard miller, also known as mm model3. The patterns of corporate capital structures around the world are also discussed. The modiglianimiller mm theorems are a cornerstone of finance for two reasons. Capital structure theory modigliani and miller mm approach the modigliani and miller approach to capital theory, devised in the 1950s, advocates the capital structure irrelevancy theory. The original propositions mmproposition i mm 1958 a. As the result, it can be concluded whether the mm theorem works and is relevant for those three companies named above. In fact, the lifetime of the company is always, of course, finite and the inclusion of this significantly changes formulae obtained by mm, in particular for the weighted average cost of capital wacc. The modigliani and miller approach to capital theory, devised in the 1950s, advocates the capital structure irrelevancy theory. Creditors receive the safe or the safest part of ebit. Capital structure a reading prepared by pamela peterson drake outline 1. Leading theories of capital structure capitalstructure irrelevance this theory holds that firm value and real investment decisions are, with few important exceptions, independent of financing.
The key modiglianimiller theorem was developed in a world without taxes. Theories of capital structure ppt free download as powerpoint presentation. Mar 25, 2014 capital structure theories c modigliani miller model mm mm model proposition o as per mm, identical firms except capital structure will have the same level of earnings. We have only recently discovered that capital structure changes convey information to investors. Outside the mm construct, this theory views capital structure as a decision that balances costs and benefits. Capital structure is the mix of ownersupplied capital equity, reserves, surplus and borrowed capital bonds, loans that a firm uses to finance business. Theories of capital structure ppt capital structure. Pdf proving modigliani and miller theories of capital structure. The value of the firm is independent of its capital structure. We do not know how firms choose the debt, equity or hybrid securities they issue.
This is because ultimately, its value is that of the cash flows generated by its operating assets e. It says that the capital structure is irrelevant to the value of a firm. This paper discusses five theories of capital structure which has been mostly argued in literature. Capital structure policy involves a tradeoff between risk and return. The criticism of the modigliani and miller hypothesis.
Aug 26, 20 net operating income theory this theory was propounded by david durand and is also known as irrelevant theory. Ebit is unaffected by a change in capital structure recall that we assumed no taxes for now. The definition states that the market value of a company is calculated. Also tells us to be careful when using pe ratios, e. Irrelevance theorem a benchmark striking result is that under fairly general conditions, the value of the firm defined as the sum of value of debt and. Different financial transactions are taxed differently.
We have identified four categories of determinants of capital structure. Oct 02, 2019 the traditional theory of capital structure states that a firms value is maximized when the cost of capital is minimized, and the value of assets is highest. Thus the higher the risk and volatility in the economy, the lower the proportion of debt in the capital structure should be. Capital structure is the mix of ownersupplied capital equity, reserves, surplus and borrowed capital bonds, loans that a firm uses to finance business operations. The choice between debt and equity is not totally unimportant its effects on real decisions are second or thirdorder. Modigiliani miller approach and arbitrage financial. Essentially, they hypothesized that in perfect markets, it does not. Expected eps might increase but eps has become riskier.
A firms capital structure of a company does not affect its overall value. Valueirrelevance proposition by the modiglianimiller modiglianimiller mm proposition is the first theory about capital structure. A net income ni approach durand presented the net income approach which suggested. Capital structure does not influence managers investment decisions 8 capital structure and corporate taxes are taxed. Mm intuition 1 if firm a were to adopt firm bs capital structure, its total value would not be affected and vice versa. Debt is the senior claimant to the firms returns and equity is the residual claimant. Does it provide a theory of capital structure for such. According to mm proposition, firm value is irrelevant to capital structure or financing decision. List of capital structure theories theories of capital structure static tradeoff theory, pecking order theory, modified pecking order theory with graphs 1.
Modigliani and miller, two professors in the 1950s, studied capitalstructure theory intensely. The theory of the capital cost and the capital structure by modigliani and miller mm is based on many assumptions, removal of which significantly alters its conclusions. Under static tradeoff, the company should continue to capitalize itself with debt until the increased costs associated with financial distress exceed the value of the tax shield. Weighted average cost of capital in the theory of modigliani. Since then, many economists have followed the path they mapped. Dec 28, 2015 download free pdf study materials in financial management. Capital structure and its 4 important theories ni, noi. The above assumptions and definitions described above are valid under any of the capital structure theories. Capital structure theories c modigliani miller model mm mm model proposition o as per mm, identical firms except capital structure will have the same level of earnings. Top 4 theories of capital structure with calculations. The capital structure puzzle is unravelled and a clear picture is presented in terms of why capital structure matters. This note provides an overview of the current state of capitalstructure theory. Hence, theories of capital structure often assume some cost of bankruptcy that increases in debt, and derive optimal capital structure as the balance between the tax benefit and the bankruptcy cost.
Mm set out their stochastic wares very early in their analysis. The theory of capital structure 299 tion of the relationships among similar models. The theorem was developed by economists franco modigliani and merton miller in 1958. The theory provides insight into a firms capital structure decision in a capital market free of taxes, transaction costs, and other frictions. Mm capital structure theory pdf stock technical analysis basics pdf. Doc capital structure theory modigliani and miller mm. Pdf the modigliani and millercapital structure of corporations. Nevertheless, beyond this, the mm theorem is a way of thinking in terms of the. Chapter iii concepts and theories of capital structure and profitability. The capital structure theory and its practical implications. Capital structure theories may be classified on the basis of relevance of capital structure to the valuation of a firm. But, in practice, bankruptcy costs exist and these. Modiglianimiller theorem financing decisions are irrelevant.
No tax scenario modigliani and millers proposition 1 involves about irrelevancy of the value to capital structure. Higher risk tends to lower a stock price, but a higher expected return raises it. They mm pointed the direction that such theories must take by showing under what conditions capital structure is irrelevant. Modiglianimiller and capital structure theory finance train. In capital structure theories, the theory of modigliani and miller. Capital structure theory modigliani and miller mm approach. The mm theory explains the effects a firms capital structure may have on the value of the company for investment purposes.
David durand views, traditional view and mm hypothesis are tine important theories on capital structure. Raising of capital from different sources and their use in different assets by a company is made on the basis of certain principles that provide a system. Modiglianimiller theorem under some assumptions, corporate. The study of capital structure attempts to explain how listed firms utilise the mix of various forms of securities in order to finance investment. In this article, we consider the wacc of the company in the theory of mm and modify mm s theory for a finite lifetime company. It is the employment of an asset source of finance for which. Theories of capital structure explained with examples. The capital structure puzzle myers 1984 the journal of. Capital structure theory asks what is the optimal composition between debt and equity. Another way to generate balanced conclusions is to account for. Since the value of the firm depends neither on its dividend policy nor its decision to raise capital by issuing stock or selling debt, the modiglianimiller theorem is often called the capital structure irrelevance principle. By reconciling empirical evidence with theory practical strategies for managing capital structure in transition are suggested. Through this equation modigliani and miller 1958 have. The modern theory of capital structure began with the celebrated paper of modigliani and miller 1958.
Modiglianimiller theorem meet the berkeleyhaas faculty. Modigliani and miller advocate capital structure irrelevancy theory, which suggests that the valuation of a firm is irrelevant to the capital structure. The existence of an optimum capital structure is not accepted by all. The firms financial policy divides up this cashflow pie among different claimants e. Finance scholars approach to capitalstructure issues reflects a progression of thought over time. The modigliani and miller hypothesis is identical with the net operating income approach. The traditional theory of capital structure says that for any company or investment there is an optimal mix of debt and equity financing that minimizes the wacc and maximizes value. The journal of online education, new york, january 2009 capital structure and ownership structure.