Theory of Irrelevance of Capital Structure

Theory of Irrelevance of Capital Structure

1. Presentation By:- Tanushree S Guided By:- Mervin Felix Caleb THEORY OF IRRELEVANCE OF CAPITAL STRUCTURE T

2. THEORY OF IRRELEVANCE OF CAPITAL STRUCTURE

3. INTRODUCTION Capital structure is the proportion of debt and preference and equity shares on a firm’s balance sheet. Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and thereby maximum value of the firm. Capital structure theories explain the theoretical relationship between capital structure, overall cost of capital (k0) and valuation (V ). Modigliani and Miller’s (1958) irrelevance theory of capital structure was a landmark research in the field of finance.

4. HISTORY OF THE M&M THEORY Merton Miller and Franco Modigliani conceptualized and developed this theorem, and published it in an article, "The Cost of Capital, Corporation Finance and the Theory of Investment,“ - American Economic Review in the late 1950s. 2 At the time, both Modigliani and Miller were professors at the Graduate School of Industrial Administration at Carnegie Mellon University. Both were required to teach corporate finance to business students but, unhappily, neither had any experience in corporate finance.

5. After reading the course materials that they were to use, the two professors found the information inconsistent and the concepts flawed. So, they worked together to correct them. The result was the groundbreaking article published in the economic journal. The information was eventually compiled and organized to become the M&M theorem.

6. INTRODUCTION TO THEORY OF IRRELEVANCE In developing their theory, Miller and Modigliani first assumed that firms have two primary ways of obtaining funding: equity and debt. While each type of funding has its own benefits and drawbacks, the ultimate outcome is a firm dividing up its cash flows to investors, regardless of the funding source chosen. This means that in the absence of taxes, bankruptcy costs, agency costs and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. 1

7. IRRELEVANCE PROPOSITION THEOREM ( CONT.) The irrelevance proposition theorem was developed by Merton Miller and Franco Modigliani in 1985. The theory implies that there is no such thing as an optimal capital structure. The theory shows that, under certain restrictive set of assumptions, the value of the firm is unaffected by its capital structure.

8. ASSUMPTIONS UNDERLYING THE PROPOSITION No agency costs: no costs arise out of increased leverage. Revenue from operations are independent of how the operations are financed. Capital markets are perfectly competitive . No transaction costs, taxes or bankruptcy costs. Under these assumptions, the capital structure is irrelevant.

9. CRITICISM Criticisms of the irrelevance proposition theorem focus on the lack of realism in removing the effects of income tax and distress costs from a firm’s capital structure. Many factors influence a firm’s value, including profits, assets and market opportunities, testing the theorem becomes difficult. For economists, the theory instead outlines the importance of financing decisions more than providing a description of how financing operations work.

10. Irrelevance Proposition Theorem - example ABC Company is valued at $200,000. According to the irrelevance proposition theorem, the valuation of the company will remain the same regardless of its capital structure i.e., the net amount of cash or debt or equity that it holds in its account books. The role of interest rates and taxes, external factors that could significantly affect its operational expenses and valuation -completely eliminated.

11. As an example, consider that the company holds $100,000 in debt and $100,000 in cash. The interest rates associated with debt servicing or cash holdings are considered to be zero. Now suppose that the company makes an equity offering of $120,000 in shares and its remaining assets, worth $80,000, are held in debt. After some time, ABC decides to offer more shares, worth $30,000 in equity, and reduce its debt holdings to $50,000.

12. This move changes its capital structure and, in the real world, would become cause to reassess its valuation. But the irrelevance proposition theorem states that the overall valuation of ABC will still remain the same because we have eliminated the possibility of external factors affecting its capital structure.

13. CONCLUSION The MM argument is simple, the total cash flows a company makes for all investors (debt holders and shareholders) are the same regardless of capital structure. Changing the capital structure does not change the total cash flows. Therefore the total value of the assets that give ownership of these cash flows should not change.

14. REFERENCES https://breakingdownfinance.com/finance-topics/equity-valuation/capital-structure-irrelevance-proposition/#:~:text=The%20Capital%20Structure%20Irrelevance%20Proposition,and%20Franco%20Modigliani%20in%201958 . https://www.investopedia.com/terms/i/irrelevance-proposition-theorem.asp https://moneyterms.co.uk/capital-structure-irrelevance/ https://www.cram.com/essay/Modigliani-And-Millers-Irrelevance-Theory-Of-Capital/PJ7CSJCHNF6 https://slideplayer.com/slide/11908248/

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