Modigliani and Miller’s Capital Structure Theories

Proposition I: In the 1950s, two American Professors, Modigliani and Miller studied the capital structure and its relationship with the value of a company and hypothesized capital structure irrelevant proposition. According to their proposition, the value of a company is not dependent on the capital structure rather it is determined by earning potential of the company. Thus the total value of the company will not change by changing gearing level or funding proportion of debt and equity.

Their proposition was based on following assumptions:

  • Ignoring Taxation
  • No Bankruptcy and Transaction Cost
  • Both individual and company has same information available

Although in the real world, all mentioned above presents but it is important to understand how the M&M proposition works after including tax implication.

Proposition II: In the 1963s, they amend their first model by including the impact of taxation, in which return on debt is tax deductible while return on equity in not. So, a geared company has the advantage because it pays the lesser tax than ungeared one and has greater market value with a lower weighted average cost of capital.

In Summary, by assuming no tax, M&M proposition I states that capital structure (combination of debt and equity to fund business operation) is irrelevant to value of the company whereas after including Tax, M&M proposition II describes that the company with greater proportion of debt have more market value because of tax benefit/ credits.

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