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Franco Modigliani and Merton Miller Theory

Prepared by Shriprasad Gaonkar

Introduction

Presented as a paper in 1958 Received Noble prize for this work and other contributions to economic research Initiated the modern discussion of the amount of debt corporations should use The paper is so well known that, for more than 30years financial economists have referred to this theory as MM theory

Definition of 'Modigliani-Miller Theorem - M&M'

Market value of a firm is determined by its earning power and the risk of its underlying assets, and is independent of the way it chooses to finance its investments or distribute dividends. Remember, a firm can choose between 3 methods of financing: issuing shares borrowing spending profits (as opposed to dispersing them to shareholders in dividends).
Read more: http://www.investopedia.com/terms/m/modiglianimillertheorem.asp#ixzz2BELiO1wP

What the theory says.

M&M showed that the value of a firm ( and of its cash flows) is independent of the ratio of debt to equity used by the firm in financing its investments This stunning conclusion was based on certain assumptions that are not true of the real world: there are no corporate personal taxes people have perfect information individuals and corporations can borrow at the same rates how you pay for an asset does not affect productivity.

A funny analogy.

"Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as is. Or he can separate out the cream and sell it at a considerably higher price than the whole milk would bring. (That's the analog of a firm selling low-yield and hence high-priced debt securities.) But, of course, what the farmer would have left would be skim milk with low butterfat content and that would sell for much less than whole milk. That corresponds to the leveraged equity. The M and M proposition says that if there were no costs of separation (and, of course, no government dairy-support programs), the cream plus the skim milk would bring the same price as the whole milk." Read more: http://www.investopedia.com/terms/m/modiglianimillertheorem.asp#ixzz2BESC8iCx

Case study

Think of 2 firms that are identical in all respects, except that one is financed completely with equity other uses some combination of equity and debt Let Ms. E buy of all equity firm; she buys 10 percent of the outstanding shares Mr. D buys 10 percent of the leveraged firm; he buys 10 percent of shares and 10 percent of the debt.

What do Ms. E and Mr. D get back for their investments? In the all equity firm, Ms. E has a claim on 10 percent of the total profits of the firm. In the leveraged firm, however the debt holders must receive their interest payments before the shareholders receive the remaining profits. Thus, for his share holdings, Mr. D gets 10 percent of the profits after interest payments to debt holders are subtracted.

But, because Mr. D also holds 10 percent of the bonds, he receives 10 percent of the profits that were paid out as interest payments. The net result for Mr. D, He receives 10 percent of the total profits just as Ms. E does.

But

This reasoning led M&M to argue that the leveraged firm and the all equity firm must have the exact same value The value of the equity firm is the value of the outstanding stock The value of the leveraged firm is the value of the outstanding stock plus the value of the outstanding debt. Because the firms are identical in the level of total profits and identical in the cash payouts paid to the investors, Ms. E and Mr. D would pay identical amounts for their respective holdings.

M&M went on to show that if the leveraged and all equity firms do not have the exact same value, arbitragers can make guaranteed risk free profit by selling the overvalued firm and buying the undervalued firm

The proposition that the ratio of debt to equity is irrelevant to the value of the company is known as the irrelevance proposition.