The Modigliani-Miller (M-M) posits that in the absence of taxes a firm’s market value and the cost of capital remain invariant to the structures changes.
Assumptions
The M-M hypothesis can be explained in terms of their propositions I and II whose assumption as described below.
• Prefect capital markets: securities (share and debt instruments) are traded in the perfect capital market situation. This specifically means that (a) investors are free to buy or sell securities (b) they can borrow without same term as the firm do; and (c) they behave rationally. It is also implied that the transaction costs i.e. the cost of buying and selling securities do not exist
• Homogeneous risk classes: firm can be grouped in to homogenous risk classes. Firms would be considered to belong to a homogenous risk class if their expected earnings have identical risk characteristics. It is generally implied under the M-M hypothesis that firms within same industry constitute a homogenous class.
• Risk: The risk of investors is defined it terms of the variability of the net operating income (NOI), the probability that the actual value of the firm may turn out to be different than their best estimate.
• No taxes: In the original formulation of their hypothesis M-M assume that no corporate income taxes exist.
• Full payout: Firms distribute all net earning to the shareholders which means a 100 per cent payout.
