The Criticism Of The Modigliani And Miller Hypothesis Finance Essay

The Criticism Of The Modigliani And Miller Hypothesis Finance Essay Capital structure has a major implication to the ability of firms to meet the various needs of stakeholders. There were various studies carried out on capital structure and major development on new theories for optimal debt to equity ratio. The first milestone on the issue was set by Modigliani and Miller(1958) through which they presented in their seminal work two important propositions that shaped the economic theory behind capital structure and its effect on firm value. The Modigliani and Miller hypothesis is identical with the net operating income approach. At its heart, the theorem is an irrelevance proposition, but the Modigliani-Miller Theorem provides conditions under which a firms financial decisions do not affect its value. They argue that in the absence of taxes, a firms market value and the cost of capital remain invariant to the capital structure changes. In their 1958 articles, they provide analytically and logically consistent behavioural justification in favour of their hypothesis and reject any other capital structure theory as incorrect. The Modigliani-Miller theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, a companys value is unaffected by how it is financed, regardless of whether the companys capital consists of equities or debt, or a combination of these, or what the dividend policy is. Miller (1991) explains the intuition for the Theorem with a simple analogy. Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as it is. Or he can separate out the cream, and sell it at a considerably higher price than the whole milk would bring. He continues, The Modigliani-Miller proposition says that if there were no costs of separation, (and, of course, no government dairy support program), the cream plus the skim milk would bring the same price as the whole milk. The main content of the argument is that increasing the amount of debt (cream) lowers the value of outstanding equity (skim milk) and selling off safe cash flows to debt-holders leaves the firm with more lower valued equity,thus keeping the total value of the firm unchanged. Furthermore, any gain from using more of what might seem to be cheaper debt is offset by the higher cost of now riskier equity. Assumptions: The Modigliani-Miller theorem can be best explained in terms of their proposition 1 and proposition 2. However their proposition are base on certain assumption and particularly relate to the behaviour of investors, capital market, the actions of the firm and the tax environment. According to I.M Pandey(1999) the assumptions of the Modigliani Miller theorem is based on: Perfect capital markets These are securities (shares and debt instruments)which are traded in the perfect capital market situation and complete information is available to all investors with no cost to be paid. This also means that an investor is free to buy or sell securities, he can borrow without restriction at the same terms as the firm do and he behave rationally. It also implies that the transaction cost(cost of buying and selling securities) do not exist. Homogeneous risk classes Firms can be group into homogeneous risk classes. Firms would be considered to belong to a homogeneous risk class if their expected earnings have identical risk characteristics. It is generally implied under the M-M hypothesis that firms within same industry constitute a homogeneous class. Risk The risk of the investors is defined in terms of the variability of the net operating income(NOI). The risk of investors depends on both the random fluctuations of the expected NOI and the possibility that the actual value of the variable may turn out to be different than their best estimate. No taxes In the original formulation of their hypothesis, M-M assume that no corporate income taxes and personal tax exist. That is, they are both perfect substitute. Full payout Firms distribute all net earnings to the shareholders, which means a 100% payout. Proposition 1: the market value of any firms is independent of its capital structure. M-M(Modigliani and miller) argue that for firms in the same risk class the total market value is independent of the debt-equity mix and is given by capitalizing the expected net operating income by the rate appropriate to that risk class. This is their proposition 1 and can be expressed as follows: Value of firm= Market value of equity + Market value of debt = V= (S + D) = = Where V = the market value of the firm S = the market value of the firms ordinary equity D = the market value of debt = the expected net operating income on the assets of the firm = the capitalization rate appropriate to the risk class of the firm. Also, M-M extended proposition 1 by arguing that there is a linear relationship between cost the cost of equity and the financial leverage. Financial leverage is measured by the Debt to Equity ratio(D/E).The cost of equity capital can be denoted by the following relationship: = + ( ) DE Where denotes cost of equity capital; denotes overall cost of capital and denotes cost of debts of the firm L . Based on the assumption that there is no corporate tax then is equal to the rate of interest on financial leverage employed by the firm. The diagram below shows the cost of capital under the Modigliani and Miller proposition 1.http://htmlimg3.scribdassets.com/2vohdy2ptsw5n23/images/12-7ef603c995.jpg Example: Example 1 Example 2 DE 2/3 1 0.18 1.18 0.10 0.10 23.3% 26% It can be seen that due to an increase in financial leverage the risk premium of equity shareholders have increased from (23-18) = 5% to (26-18) = 8 %. We can also verify for the , which is given below: When debt equity ratio is 2:3 + = 18% The similar result is obtained when DE is 1. + = 18% It can be concluded that the overall cost of capital, which is the weighted average cost of debt and cost of equity, is unaffected even if the degree of financial leverage is increased. As per the M-M model, however , any benefits arising by substituting cheaper leverage for more expensive equity are offset by an increase in both the costs as reflected on the following graph. Arbitrage process: Arbitrage process is base on the principle that Proposition 1 is based on the assumption that 2 firms are identical except for their capital structure which cannot command different market value and have different cost of capital. Modigliani and Miller do not accept the net income approach on the fact that two identical firms except for the degree of leverage, have different market values. Arbitrage process will take place to enable investors to engage in personal leverage to offset the corporate leverage and thus restoring equilibrium in the market. Criticism of the Modigliani and Miller hypothesis: On the basis of the arbitrage process, M-M conclude that the market value of firms are not affected by leverage but due to the existence of imperfections in the capital market, arbitrage may fail to work and may give rise to differences between the market values of levered and unlevered firms. The arbitrage process may fail to bring equilibrium in the capital market for the following reasons: Lending and borrowing rates differences: Based on the assumption that firms and individuals can borrow and lend at the same rate of interest does not hold good in practice. This is so because firms which hold a substantial amount of fixed assets will have a higher credit standing, thus they will be able to borrow at a lower rate of interest than individuals. Non-substitutability of personal and corporate leverages: It is incorrect to say that personal leverage and corporate leverage are perfect substitute because of the existence of limited liability a firms hold compare to the unlimited liability of individuals hold. For examples, if a levered firm goes bankrupt, all investors will lose the amount of the purchase price of the shares. But if an investor creates personal leverage, in the event of a unlevered firms insolvency, he would lose not only his principal in the shares but also be liable to return the amount of his personal loan. Transaction costs: Transaction cost interfere with the working of the arbitrage. Due to the cost involved in the buying and selling of securities, it is necessary to invest a larger amount in order to earn the same return. As a result , the levered firm will have a higher market value. Institutional restrictions: Personal leverage are not feasible as a number of investors would not be able to substitute personal leverage for corporate leverage and thus affecting the work of arbitrage process. Corporate taxation and personal taxation: M-M theory is also criticize for the reason that it ignores the corporate taxation and personal taxation. Retained earnings: It also ignores personal aspect of financing through retained earnings. In real world , corporate will not pay out the entire earnings in the form of dividends. Investors willingness: Investors will not show much interest in purchasing low rated issued by highly geared firms.