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Modigliani and Miller, two professors in the 1950s, studied capitalstructure theory intensely. From their analysis, they developed the
capital-structure
irrelevance
proposition.
Essentially,
they
hypothesized that in perfect markets, it does not matter what capital
structure a company uses to finance its operations. They theorized
that the market value of a firm is determined by its earning power and
by the risk of its underlying assets, and that its value is independent
of the way it chooses to finance its investments or distribute
dividends.
The basic M&M proposition is based on the following key assumptions:
No taxes
No transaction costs
No bankruptcy costs
meaning
companies
and
Arbitrage process
Arbitrage process is the operational justification for the
Modigliani-Miller hypothesis. Arbitrage is the process of purchasing a
security in a market where the price is low and selling it in a market
where the price is higher. This results in restoration of equilibrium in
the market price of a security asset. This process is a balancing
operation which implies that a security cannot sell at different prices.
The MM hypothesis states that the total value of homogeneous firms
that differ only in leverage will not be different due to the arbitrage
operation. Generally, investors will buy the shares of the firm that's
price is lower and sell the shares of the firm that's price is higher. This
process or this behavior of the investors will have the effect of
increasing the price of the shares that is being purchased and
decreasing the price of the shares that is being sold. This process will
continue till the market prices of these two firms become equal or
identical. Thus the arbitrage process drives the value of two
homogeneous companies to equality that differs only in leverage.
Limitations of MM hypothesis:
1. Investors would find the personal leverage inconvenient.
2. The risk perception of corporate and personal leverage may be
different.
3. Arbitrage process cannot be smooth due the institutional
restrictions.
4. Arbitrage process would also be affected by the transaction
costs.
5. The corporate leverage and personal leverage are not perfect
substitutes.
6. Corporate taxes do exist. However, the assumption of "no taxes"
has been removed later.