MODIGLIANI–MILLER APPROACH - Accounts and Finance for Managers

It is the approach, attempts to explain the application of leverage does not have any influence on the value of the firm through behavioural pattern of the investors. The behavioural pattern of the investors is taken into consideration for explaining the value of the firm which is unaffected by the application of debt/leverage in the capital structure through arbitrage process. The MM approach has three different propositions:

  1. The overall capital structure of the firm is unaffected by the cost of capital an degree of leverage
  2. The cost of equity goes up and offset the increase of leverage in the capital structure
  3. The cut off rate for the investment purposes is totally independent.

For discussion, the proposition is only considered for the study of usage of leverage in the capital structure, which do not have any impact in the value of the firm.

Assumptions of the MM approach:

This approach is discussed under the perfect market conditions

  1. Securities are divisible infinitely.
  2. Investors are allowed to buy and sell securities
  3. Investors are rational to access the information
  4. No transaction costs involved in the process of the buying and selling of securities

Arbitrage process: It is the process facilitates the individual investors to buy the investments at lower price at one market and sells them off at higher price in another market. With the help of arbitrage process, the investors are permitted to shift holding of the Levered firm to the unlevered firm which is known as undervalued. These two firms are identical in business risk except in the application of debt finance in the levered firm. In order to maintain the similar amount of the financial risk of the firm, the investor is required to undergo for personal leverage or home made leverage to maintain the same proportion of investment in the unlevered firm. During this process, the investor could save something and this continuous arbitrage process will level the value of the both firms. It means that the value of the firm is unaffected by the application of leverage which is explained through the arbitrage process, nothing but behavioural pattern of the investors.

The same thing could be applied in the case of reverse arbitrage process in between the Unlevered and levered. This also another kind of process in which the investor could gain through the transfer of the holdings from the unlevered firm to levered firm.

The value of the firm is unaffected by the application of the leverage in the capital structure


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