Having difficulty understanding Modigliani and Miller’s first proposition? - UOL FInancial Management Tuition in Singapore

UOL FInancial Management Tuition in Singapore

Modigliani and Miller’s first proposition

The propositions on capital structure made by Modigliani and Miller (M&M) are among the most important contributions in the theory of finance. Capital Structure, in its broadest term, can be defined as proportion of debt and equity used by the firm to finance its economic balance sheet. 

The first propositions made by MM states that the market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the rate r appropriate to its class”, Modigliani and Miller [1958, page 268]. This implies that, capital structure is irrelevant, and firm value is equal to the present value of the free cash flow discounted at the relevant cost of capital.

They assume that:

A)  Capital markets are 

-  Markets are frictionless. that is., there is no transaction cost where the borrowing rate = lending rate, no taxes and all assets are perfectly divisible and 

- Perfect competition in product and securities markets. Among other things, this imply that all producers and consumers are price 

- Information efficiency. That is, information is costless, and is received simultaneously by all individuals, both corporate insiders and outsiders (this implies no 

- Agents are perfectly rational and use it to maximize there utility

B)  There is no cost to bankruptcy.

C)  Firms issue risky debt and equity, and have the same beta risk.

D) All cash flow streams are perpetuities, and no growth is allowed.

E) Allowing for proportional corporate tax eases the no-tax assumption above.

F) Managers always maximize the shareholders’ wealth thus implying that there is no agency costs.

G) Homemade leverage is a perfect substitute for corporate leverage. That is, there is no difference between corporate and personal borrowing (necessary for arbitrage arguments)

As such, the first proposition concluded that with the assumptions above, 

VL = Vu (Value of levered firm = value of un-levered firm regardless of the proportion of debt and equity used in the firm) 

UOL Modules that are taught by Us:

1. Introduction to Economics

2. Principles of Banking & Finance

3. Corporate Finance

4. Financial Management

5. Principles of Accounts

6. Statistics 1

7. Statistics 2

8. Maths 1

9. Maths 2

10. Elements of Econometrics

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