Modigliani and Miller assumed that firms do not grow. How does positive growth change their conclusions about the value of the levered firm and its cost of capital?

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Modigliani and Miller assumed that firms do not grow. How does positive growth change their conclusions about the value of the levered firm and its cost of capital?

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Modigliani and Miller assumed that firms do not grow. How does positive growth change their conclusions about the value of the levered firm and its cost of capital?

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Answer

Under Modigliani-Miller without taxes, where there are no corporate or personal income taxes.
According to Modigliani-Miller Proposition I, the value of levered firm will equal the value of an unlevered firm. The capital structure will not affect the weighted average cost of capital.
If the value of two companies differed only:
(1) In the way they are financed
(2) In their total market values
 
Then investors would sell the shares of the higher-valued firm and buy the shares of the lower-valued firm, and continue this process until the companies had exactly the same market value.
 
For instance: An investor holding shares of a levered firm, which has 10%, debt sells those shares. Since the return from a levered firm equals o the return from an unlevered firm. The investor will borrow funds equals to 10% of debt of the levered firm to purchase 10% shares of an unlevered firm. In this case, after the purchase of shares the investor will have remaining amount of borrowed fund. This situation will lead to the decline in the price of a levered firm shares and increase in the share price for an unlevered firm.
Assumption under Modigliani-Miller
• Level of business risk of the firms should be homogeneous. Different level of risk will have different cost of capital therefore the valuation of the firm by the market will be at different rates. Thus. capitalization of the earnings will also be at different rates.
• Investor's expectation about the future earnings of the company will be same for the firms. If investors have different perception about the firms' earnings, then the value of the firm will also be different which eliminates the arbitrage opportunity.
• There are no brokerage charges and both the firm and an individual can borrow at the same rate of interest from the market. Stock and debt trade only in a perfect market.
• Investor who invest and trade in the market are rational. If in case the investors are irrational, they will not know about an arbitrage opportunity and will lock in their investments with the respective firms.
• No corporate taxes. In case of no corporate taxes only, both the levered and unlevered firm value will be equal. Otherwise, the value of levered firm will be value of unlevered firm and the tax shield obtained from the debt.

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