INDRESH PRATAP SINGH is teaching live on Unacademy Plus
MODI MILLER Approach (MM Approach) This theory is invented by Modigliani and Miller The MM Approach is identical with the NOl approach MM argued that in the absence of tax, cost of capital and the value of the are not effected by the change in capital structure. In other words, capital structure decision is irrelevant and the value of the firm is independent of debt-equity mix
Basic Prepositions The theory based on two prepositions- 1. ko and the value of the firm are independent of the capital structure The financial risk increases with more debt content in the capital structure, as the result ke increases in a manner to offset exactly the low cost advantage of debt. So, ko remain same 2.
0 0 Degree of Leverage
Assumptions of MM approach There is exists a perfect capital market Capital market are perfect when-: Investors are free to buy and sell securities Investors behave rationally They are well informed and information is costless There is no transaction cost They can borrow funds without restrictions Firms can be classified into homogeneous risk class, means there is same degree of financial risk . Dividend payout ratio is 100% There us no corporate tax. MM remove this assumption later
Criticism of MM approach . Risk perception of personal and corporate leverages are different- It was assumed that personal leverage is perfect substitute of corporate leverage. Borrowing rate of firm and individuals are same- This assumption does not hold good in practice. Institutional restrictions
Trade-off theory of Capital Structure This theory is also invented by Modigliani and Miller. Modigliani and Miller in their article of 1963 have recognized that the value of the firm will increase and the WACC will decrease with the use of debt in capital structure. After many criticism they realized that there is tax saving effect of debt instrument and debt is the cheapest source of finance which have positive effect on capital.
equity debts VALUE equity ko Optimum Capital Structure Reducing equity Mixing more debts debts debts debts equity equity Imbalance will create ke rise and consequently lead ko rise