Who were Modigliani and Miller (MM), and what assumptions are embedded in the MM and Miller models?
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David Lyons, CEO of Lyons Solar Technologies, is concerned about his firm’s level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies have debt, and Mr. Lyons wonders why they use debt and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions |
Explanation
Franco Modigliani and Merten Miller are two economists who created a corporate valuation model called the Modigliani and Miller (MM) in 1958. This model suggests that the capital structure of the company does not affect the overall value of the company.
The Modigliani and Miller model work under the assumption that the company operates in a perfectly efficient market. The perfectly efficient markets have the following implications-
The risk embedded in the firm's operations is measured by the deviation of EBIT. The firms falling in the same business classes can be grouped together
The cash flows are perpetual with zero growth. The firm payout all the earnings as dividend and hence there is no growth.It is also assumed that the expected EBIT is constant.
Annual tax savings are proportionate to annual debt, so the tax shield is discounted at the cost of debt.
Companies do not pay any taxes. Thus, the company does not obtain any tax benefits from inclusion of debt in the capital structure.
All the investors have the same expectations regarding the earnings or EBIT of the firm.
There are no transaction costs to both the participant, the firms and the investors.
Firms can borrow unlimited amounts of money at the same risk free rate.
However, in the real world, the assumptions do not persist and it is not guaranteed to generate the required results with the help of Modigliani and Miller (MM) approach.
Verified Answer
Franco Modigliani and Merten Miller are two economists who jointly created a corporate valuation model called the Modigliani and Miller (MM) in 1958.
The Modigliani and Miller model work under the major assumption that the company operates in a perfectly efficient market with zero growth rate and no taxes.
