Modigliani & Miller Approach

One of the 4 approaches of theories of capital structure.

1. Modigliani AND miller approach Guided By: Dr. Girija Nandini Presented By: Sunanda Priyadarshini 200402100026

2. THEORIES OF CAPITAL STRUCTURE DIFFERENT AUTHORS TRIED TO EXPLAIN THE REATIONSHIP BETEEN CAPITAL STRUCTURE , COST OF CAPITAL AND VALUE OF THE FIRM . VALUE OF THE FIRM COST OF CAPITAL

3. MM APPROACH: WITHOUT TAXES (1958) MM APPROACH: WITH TAXES (1963)

4. THE FIRM’S MARKET VALUE IS NOT AFFECTED BY CAPITAL STRUCTURE. FIRMS BORROW BY OFFERING INVESTORS TYPES OF SECURITIES. MM ACCEPT THAT BORROWING INCREASES SHAREHOLDERS RETURN, BUT THEY ARGUE, IT ALSO INCREASES RISK. THEY SHOW THAT INCREASED RISK EXACTLY OFFSETS THE INCREASED RETURN, THUS LEAVING THE POSITION OF SHAREHOLDERS UNCHANGED. 6

5. ASSUMPTION OF MM THEORY

6. 8 CORPORATE TAXES ARE ASSUMED TO EXIST

7. EXAMPLE COMPANY XYZ – 10,00,000 EQUITY – 5,00,000 & DEBT – 5,00,000 INCOME – 5,00,000 EXPENSES – 3,00,000 EBIT – 2,00,000 INTEREST – 10% 10% on 5,00,000 = 50,000 Earnings = 2,00,000 – 50,000 =1,50,000 Return on Equity =(1,50,000 / 5,00,000)*100 =30% COMPANY ABC – 10,00,000 EQUITY – 7,00,000 & DEBT – 3,00,000 INCOME – 5,00,000 EXPENSES – 3,00,000 EBIT – 2,00,000 INTEREST – 10% 10% on 3,00,000 = 30,000 Earnings = 2,00,000 – 30,000 = 1,70,000 Return on Equity =(1,70,000 / 7,00,000)*100 =24.28%

8. EXAMPLE COMPANY ABC – 10,00,000 EQUITY – 7,00,000 & DEBT – 3,00,000 INCOME – 5,00,000 EXPENSES – 3,00,000 EBIT – 2,00,000 INTEREST – 10% 10% on 3,00,000 = 30,000 Earnings = 2,00,000 – 30,000 = 1,70,000 TAXES – 30% 30% on 1,70,000 = 51,000 Earnings = 1,70,000 – 51,000 = 1,19,000 COMPANY XYZ – 10,00,000 EQUITY – 5,00,000 & DEBT – 5,00,000 INCOME – 5,00,000 EXPENSES – 3,00,000 EBIT – 2,00,000 INTEREST – 10% 10% on 5,00,000 = 50,000 Earnings = 2,00,000 – 50,000 =1,50,000 TAXES – 30% 30% on 1,50,000 = 45,000 Earnings = 1,50,000 – 45,000 =1,05,000

9. EBIT VALUE OF UNLEVERED FIRM (V u ) = K o VALUE OF LEVERED FIRM (V L ) = V u + t * D EBIT – Earnings Before Interest & Tax Ko – Overall Cost of Capital t – Rate of tax D – Value of debenture

10. FIRM Y EBIT – 25,000 t = 50% D = 1,00,000 Vt = Vu + t * D Vt =Rs. 2,50,000 + 0.5 * 1,00,000 = Rs. 2,50,000 + 50,000 = Rs. 3,00,000 FIRM X EBIT – 25,000 Ko – 10% EBIT Vu = Ko 25,000 100 Vu = = 25,000 10 10 100 = Rs. 2, 50,000

11. THANK YOU