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Modigliani and Miller Approach in Capital Structure Theory

The Modigliani and Miller approach refines the net operating income approach in capital structure theory. It assumes that the cost of debt is lower than the cost of equity, debt capitalization rate remains constant, and market value of the firm is not affected by debt-equity mix. With perfect capital markets, overall cost of capital stays constant regardless of the debt-equity mix, leading to no optimum capital structure. Debt may be cheaper than equity, but increases in financial risk raise the equity capitalization rate, offsetting the advantage of low-cost debt.

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Modigliani and Miller Approach in Capital Structure Theory

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  1. Modigliani and Miller Approach Modigliani and Miller Approach This approach is a refinement of the net operating income approach. Assumptions Assumptions ● The Cost of Debt (Kd) is always less than Cost of Equity (Ke). ● The debt capitalization rate remains constant at various level of debt equity mix. ● Keincreases as debt content increases due to higher financial risk and higher expectation of equity investors.

  2. ● The market capitalizes the value of the firm as a whole without giving importance to the debt equity mix. Hence, overall cost of capital is constant. ● The capital markets are perfect. Investors are free to buy and sell securities. They are well informed about the risk and return on all type of securities. There are transaction cost. ● Firms can be classified into ‘homogenous risk class’. They belong to this class, if their expected earnings have identical risk characteristics.

  3. Theory Theory ● Debt may be cheaper than equity. ● Increases in financial risk causes the equity capitalization rate to increase. ● Thus, the advantage of using low-cost debt is set off exactly by the increase in equity capitalization rate. ● Therefore, the overall cost of capital remains constant for all degree of debt equity mix.

  4. ● The market capitalizes the value of firm as a whole. ● The market value of the firm is ascertained by capitalizing the net operating income at the overall cost of capital, which is constant. The market value is not affected by changes in debt-equity mix. ● Since, WACC is constant at all levels, every debt-equity mix is as good as any other mix. There is no optimum capital structure. ● Since, WACC is constant, WACC at 0% debt should be same as WACC at any other percentage of debt. Hence, WACC=Kewhen the firm is financed purely by equity. •

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