Question

In 1958 Franco Modigliani and Merton Miller (MM) published a set of research papers that revolutionized the theory of a corporation's capital structure. In their first research paper, MM proposed a set of assumptions that, on the surface, may seem unrealistic, but these assumptions and MM's algebraic approach provided the first significant attempt to study capital structure theory in a scientific fashion. The original assumptions that were used in MM's first study were changed by MM and other researchers as the theory of capital structure evolved. Which of the following statements are assumptions that MM used in their initial model and research paper? Check all that apply. Business risk can be measured by the standard deviation of EBIT. Investors have homogeneous expectations about earnings and risk. All cash flows are perpetuities, so EBIT will remain constant. All investors have the same expectations of a firm's earnings. Consider the following statement about a firm's capital structure: The value of the firm is independent of its leverage. Is the preceding statement consistent with the conclusions of Modigliani and Miller's capital structure theory? Yes No

Answer 1

Yes.The statement that The value of the firm is independent of leverage is consistent with the M&M capital structure theory as if we analyze the other statement in the theory it becomes clear that Value of leverage firm is same as Value of un leveraged firm according to the assumptions on which M&M theory is based.

M&M theory is based on the proposition of perfect market conditions ,in which there are no taxes , transection cost and any impact of bankruptcy although bankruptcy was possibile.s since perfect market conditions don't exist this theory is best for study purpose only.

For example if we consider above statements it is absolutely clear that All cash flow of perpetuities can be possible only if there are perfect market conditions and there is no competition ,than only cash flow may remain perpetuities.

Similarly business risk can be measured only from ebita can be possible only if all other risk factors which exist in business.Investors would have homogeneous expectation of earning only in perfectly operational market conditions in which there is no loss even if there is bankruptcy.