Consider a firm with debt only. Interest payment reduce net income from operatio
ID: 2821383 • Letter: C
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Consider a firm with debt only. Interest payment reduce net income from operations. I guess it is correct to say, just like the MM theory proposes, that whether the capital structure, it doesn’t change the value of the firm. Note here it is value and not operating income. Are there any assumptions made by the MM theory? Consider a firm with debt only. Interest payment reduce net income from operations. I guess it is correct to say, just like the MM theory proposes, that whether the capital structure, it doesn’t change the value of the firm. Note here it is value and not operating income. Are there any assumptions made by the MM theory?Explanation / Answer
MM theory is a capital theory approach devised in 1950, which states that the valuation of a firm remains constant and is not affected by its capital structure. According to this approach, the market value of a firm is independent of the level of a company's financial leverage. The theory is applicable in perfect markets and suggests that it is the company's earning power and underlying risks of its investment which determines its market value.
The theory is similar to net operating income theory which also suggests that the cost of capital of a company remains constant whatever is the mix of capital structure. For if the debt increases the risk associated with equity shareholders also increases leading to a higher cost of equity. A higher cost of equity nullifies the advantages of a cheaper cost of debt. Thus, making it irrelevant to value a firm.
The theory is based on some of the key assumptions like:
a) there are no taxes
b) transaction and buying cost of securities is nil
c) No bankruptcy cost
d) There is symmetry of information and both the corporation and investors will have the same level of information
e) Borrowing cost will be the same for both investors and corporation'
f) No floatation cost and no corporation dividend tax
A perfect market does not exist and there will be taxes, bankruptcy, floating cost involved in the company. And this is the reason why MM theory was revised to include Trade off Theory of leverage. This is done to include the effect of taxes and bankruptcy cost to the firm and its effect. Earlier the theory states that the weighted average cost of company (wacc) would remain the same whatever the mix of capital structure. However, trade off theory suggests that leverage is good for the company till an optimal capital structure is reached. Leverage is good because it reaps the benefit of tax deduction on its interest expense whereas paying dividend does not.
Thus, MM theory is applicable to a market where corporate taxes does not exist, thus having no effect on the company's capital structure whereas MM II theory involves the effect of corporate taxes and bankruptcy cost on the value of the firm.
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