8. Modigliani and Miller assumptions Aa Aa In 1958 Franco Modigliani and Merton
ID: 2711286 • Letter: 8
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8. Modigliani and Miller assumptions Aa Aa In 1958 Franco Modigliani and Merton Miller (MM) published a set of financial papers that revolutionized the research of capital structure theory. MM proposed a set of assumptions that may seem unrealistic, but the assumptions and their algebraic approach provided a basis for supporting capital structure theory in a scientific fashion. The original assumptions that were used in MM's first proposal were changed by MM and other researchers as capital structure theory evolved. Which of the following statements are assumptions that MM made in their initial model? Check all that apply X X The cost of debt increases with the level of debt. Personal taxes offset the benefits derived by corporate taxes. Investors have homogeneous expectations about earnings and risk. Investors have different expectations about earnings and risk. V Explanation: Open SpeculationX is the underlying assumption necessary for MM to prove their propositions. Explanation: Open Consider the following statement about a firm's capital structure: The value of the firm is independent of its leverage. Is the preceding statement consistent with the conclusions of Modigliani and Miller's capital structure theory? Q No Explanation: Open Flash Player WIN 19,0,0,226 Q3 3.33 © 2004-2015 Aplia. All rights reserved © 2013 Cengage Learning except as noted. All rights reserved Try Another Version ContinueExplanation / Answer
The following are the basic assumptions of MM Model
The proposition that the weighted average cost of capital is constant irrespective of the type of capital structure is based on the following assumptions:
(a) Perfect capital markets: The implication of a perfect capital market is that (i) securities are infinitely divisible; (ii) investors are free to buy/sell securities; (iii) investors can borrow without restrictions on the same terms and conditions as firms can; (iv) there are no transaction costs; (v) information is perfect, that is, each investor has the same information which is readily available to him without cost; and (vi) investors are rational and behave accordingly.
(b) Given the assumption of perfect information and rationality, all investors have the same expectation5 of firm's net operating income (EBIT) with which to evaluate the value of a firm.
(c) Business risk is equal among all firms within similar operating environment that means, all firms can be divided into 'equivalent risk class' or 'homogeneous risk class'. The term equivalent/homogeneous^ risk class means that the expected earnings have identical risk characteristics. Firms within an industry are assumed to have the same risk characteristics. The categorization of firms into equivalent risk class is on the basis of the industry group to which the firm belongs.
(d) The dividend payout ratio is 100 per cent.
(e) There are no taxes. This assumption is removed later.
The model nowhere mentions that the cost of debt shall increase with increase in the debt level. Infact, upto to a particular leverage level, the cost of debt will come down with increase in debt
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