Teori Miller

ASSUMPTIONS OF MODIGLIANI & MILLER APPROACH

1. The capital markets are assumed to be perfect. This means that investors are free to buy and sell securities. They are well informed about the risk-return on all type of securities. These are no transaction costs. The investors behave rationally. They can borrow without restrictions on the same terms as the firms do.

 

2. The firms can be classified into ‘homogeneous risk class’. They belongs to this class if their expected earnings is having identical risk characteristics.

 

3. All investors have the same expectations from a firm’s net operating income (EBIT) which are necessary to evaluate the value of a firm.

 

4. The dividend payment ratio is 100%. In other words, there are no retained earnings.

 

5. There are no corporate taxes. However this assumption has been removed later.

 

Modigliani and Miller agree that while companies in different industries face different risks which will result in their earnings being capitalized at different rates, it is not possible for these companies to affect their market values, and therefore their overall capitalization rate by use of leverage. That is, for a company in a particular risk class, the total market value must be same irrespective of proportion of debt in company’s capital structure. The support for this hypothesis lies in the presence of arbitrage in the capital market. They contend that arbitrage will substitute personal leverage for corporate leverage. This is illustrated below:

 

Suppose there are two companies A & B in the same risk class. Company A is financed by equity and company B has a capital structure which includes debt. If market price of share of company B is higher than company A, market participants would take advantage of difference by selling equity shares of company B, borrowing money to equate there personal leverage to the degree of corporate leverage in company B, and use these funds to invest in company A. The sale of Company B share will bring down its price until the market value of company B debt and equity equals the market value of the company financed only by equity capital.