Ko=ke(s/v)+Kd(s/ 12(125000/12500)+10(0/125000)

=12(1)+0
v)
=12%

Ko=ke(s/v)+Kd(s/ 12.38((10500/125000)+10(20000/125000)
=10.40+1.6
v)
=12

Ko=ke(s/v)+Kd(s/ 20(25000/125000)+10(100000/125000)
=4+8
v
=12
Modigliani and Miller
Approach:
 The M-M hypothesis is similar to the
N.O.I. approach if taxes are ignored.
When taxes are assumed to exist,
their hypothesis is similar to N.I.
approach.
Modigliani and Miller Approach : [ Without Tax ] : [
Similar to N.O.I. Approach ]

 In absence of taxes, M-M approach is similar to

N.O.I. approach. According to N.O.I. approach,
the cost of capital Ko, and the value of the firm
V, remain constant. Change in capital
structure does not change the cost of
capital, Ko and value of the firm, V. There
is nothing as an optimum capital structure
and every capital structure is the optimum
capital structure. There is no relevance
between capital structure (Debt Equity Mix) and
the value of firm.
 The N.O.I. approach advocated by Prof.
David Durand is purely definitional or
conceptual. It does not give operational
justification for irrelevance of capital
structure in the valuation of the firm.
Modigliani and Miller support N.O.I.
approach by providing behavioural
justification for cost of capital and value of
the firm with change in capital structure.
ASSUMPTIONS:
1 Existence of Perfect Capital Market: It means
that –
– Investors are free to sale and purchase of
securities.
– There are no transaction costs.
– The investors can borrow for investment at the
same rate of interest as firm can borrow.
– The investors are well informed. Information is
available to all investors without cost.
– The investors behave rationally. Investors choose a
combination of risk and return that is most
advantageous to them.
ASSUMPTIONS:
2. Homogeneous risk class:
All firms within the same class have same degree
of business risk.
3. Homogeneous expectations:
All present and prospective investors have same
expectations about the future earnings of each
firm.
4. The dividend pay out ratio is 100%.
All firms distribute all of its earnings in the form of
dividend among shareholders.
5. There are no taxes.
 On the basis of the above assumptions
the M-M developed two Propositions to
explain the cost of capital, Ko, Value of
the firm, V and the capital structure.
Proposition-I : [Unlevered Firm: Purely
Equity Financing Firm]

 Cost of equity Ke = Cost of capital,

Ko i.e. Ke = Ko
Y
Capital
Cost of Ke = Ko lowest = ‘V’ greatest
capital

o x

Degree of leverage (100% equity)

 M-M hypothesis –
[Proposition-I]
 The value of the firm is ascertained by capitalising N.O.I. i.e.
EBIT at an appropriate rate of discount for its risk class:
V = EBIT
Ko
EBIT is calculated before interest on debt and therefore it is
independent of capital structure. Moreover, EBIT is affected by
the assets in which firm has invested the fund and not by
composition of funds raised to finance the assets.
In ascertaining value of firm V, EBIT and Ko both are
independent of capital structure and remain constant, and
therefore, the value of the firm ‘V’ also remains constant.
Proposition: II:
[Levered Firm : Equity + Debt Financing Firm ]

 The cost of equity Ke = Cost of capital Ko +

Premium for the financial risk
y
Ke = Ko + Premium for Financia Risk
+
Ko Ko lowest ‘V’ greatest
(Optimum Capital Structure)

Kd

X
o 20% 40% 60% 80% 100%
 The proposition-II states that as the firm increases
the proportion of debt in its capital structure, it
increases the financial risk to the shareholders.
Thus, the advantage of use of cheaper debt capital
is exactly offset by the increase in the cost of
equity, Ke and therefore, Ko remains constant. As
cost of capital, Ko remains constant, the value of
firm ‘V’ also remains constant and every capital
structure is optimum capital structure. Thus, the
basic point in the M-M hypothesis is that,
when corporate tax is ignored, the value of a
firm V, is completely unaffected by its capital
structure.
 A Ltd. has financed its project with 100% equity with a cost of 21% (Ke). This is also a
Weighted Average Cost of Capital (Ko). B Ltd., another company identical to A Ltd., has
financed its capital structure with 2.00:1.00 DER. The cost of debt, Kd, is 14%. It is a risk
free investment in debt. Calculate the cost of equity of B Ltd.

 A Ltd. (Equity Financing Firm only) B Ltd. (Equity + Debt Mix Financing Firm)
Ke = Ko Ke = Ko + Premium for financial risk
21% = 21%. = 21% + 14%
=35

Calculation of Overall Cost of Capital : Ko of B Ltd.

Debt Equity Mix Weights After Tax Cost Weighted Cost

Debt Capital 0.67 14% Kd 9.33%

Equity Capital 0.33 35% Ke 11.67%

Total 1.00 Ko 21.00%

 Proof of M-M Hypothesis:
M-M have suggested an arbitrage process to prove their
argument. They argued that two identical firms, except
their capital structure cannot have different cost of
capital and market value because of arbitrage process.
Arbitrage process is the operational justification of M-M
hypothesis.

The arbitrage process is an act of “buying shares” in

one market having “lower price” (unlevered firm) and
“selling shares” in another market having “higher
price” (levered firm).
 In arbitrage process, the shareholders of overvalued firm (levered
firm – higher price) will sell their shares in one market and buy the
shares of undervalued firm (unlevered firm – lower price) from
another market. This process will continue till both the firms attain
same market value i.e. equilibrium value of shares. When both the
firms will reach at equilibrium position, the cost of capital Ko and
value of firm V, will be equal.

For buying shares in one market, the investor will engage in

‘personal leverage’ as against ‘corporate leverage’ i.e. he will
buy shares by borrowing additional funds equal to percentage of his
holding in levered firm on personal account and invest is called
‘home made’ or ‘personal leverage’.