M&M Proposition 1
The Modigliani-Miller theorem forms the basis of modern thinking on capital structure. The theorem states that under a certain market price process, in the absence of taxes, bankruptcy cists, agency costs and asymmetric information, an in an efficient market, the value of a firm is unaffected by how the firm is financed. Whether the firm’s capital is raised by issuing stock or selling debt does not affect the value of the firm. This theory is also referred to as the capital structure irrelevance principle, which we have already looked at in previous seminar discussions. There are two propositions which were discussed by Modigliani and Miller. The first proposition states that the value if a firm does not depend on its capital structure. An example would be if two firms with the same business operations and similar kind of assets, where to be assessed after using either stocks or debt to finance the firm of s. On the left side their balance sheets, these firms will look the same, only difference being the right side, i.e. the liabilities and how they finance business activities. M&M proposition 1 therefore says that how the debt and equity is structured in a corporation is irrelevant as the value of the firm is determined by real assets and not its capital structure.
Implications of this proposition firstly revolve around the issue of changing capital structure. Assuming that the three conditions identified by M&M apply and considering a company which is financed entirely with equity. The annual cash flows of R100, which are expected to continue forever, if an appropriate discount rate is 10%, we can calculate the value of the firm to perpetuity as PVA=100/0.1= R1000. Since the firm is financed entirely with equity, the equity is worth R1000. If management was considering changing the capital structure to 80% equity and 20% debt, then