BAP53A Corporate Finance Assignment: M&M Theorem Analysis

This assignment solution delves into the core concepts of the Modigliani and Miller (M&M) Theorem, a cornerstone of modern finance theory. It begins by outlining the theorem's key principles, including the independence of a firm's market value from its capital structure and the irrelevance of dividend policy. The solution then explores the two primary propositions of the M&M Theorem, discussing the assumptions underlying the original version and the adjustments made in subsequent iterations to account for factors like taxation, bankruptcy costs, and asymmetric information. The solution further analyzes how debt financing can create tax shields, thereby increasing a firm's value, while also acknowledging the potential costs associated with financial distress. Finally, the assignment addresses the practical application of these principles in project evaluation, providing a comprehensive understanding of corporate finance decision-making. The provided solution uses the context of Blue Mountain Ltd and the new product introduction to evaluate the project's viability. The solution analyzes the project's economic life, advertising costs, interest expense, and machine purchase to assess the project's financial performance.

FUNDAMENTALS OF CORPORATE FINANCE

Out of the many finance researchers and scholars, the names Franco Modigliani and Merton
H. Miller are two most popular names, and are often referred to as the influencers of the
modern finance and economic theory. The “Modigliani and Miller Theorem” was initially
proposed in the year 1958 under the name “The Cost of Capital, Corporation Finance and the
Theory of Investment.” The relationship between the total value of companies and the
components in the capital structure is the key subject of the theorem. The three principle of
the M&M doctrine are explained below.
First principle states that the capital structure of any firm and the total market value, are not
related to each other. As per the second principle, the cost of equity of an entity, and the debt
equity ratio rise simultaneously. The third and the final principle the dividend policy does not
holds the potential cause changes to the aggregate market value of firm, which means that
both of them are not correlated to each other. Thus, the key conclusion derived Modigliani
and Miller through their research is the independence of the market value of an entity to the
financing structure. Further it has been stated in the doctrine that the changes in the net
operating income and the risk in the business lead to the fluctuations in the market value of
an entity.
It is to be noted that the above theory has been proposed with certain assumptions therein.
There are varied assumptions taken under the theory and the main of them which formed the
part of the first version of the theory was the business is not subjected to any form of
taxation. It is to be noted that such an assumption is only possible in theoretical context and
not the real life application (Ahmeti, and Prenaj, 2015). This is because, whether a developed
or a developing economy, there is some or the other form of taxation applied by the
regulators on the business entities. This is in addition to the assumption that bankruptcy costs
together with the asymmetric data are also not present.
In the second version, the researchers took into consideration the effect of the taxes,
bankruptcy costs and the fact that there is asymmetric information in the financial market
among the investors. In this version, note was given to the fact that when the debt is involved
in the financing structure, the same leads to the interest payments on regular intervals, leading
to the charge on the profit and loss account. This is referred to as the notion of tax benefit. In
contrast to the above, the equity source of finance involved dividends to the members of the
company which are not subjected to tax (Ani, 2016). The conclusion reached from the

preposition first is that the value of a levered entity is more than the unlevered firm to the
extent of the tax shield benefits for the payments to the debt owners.
(Source: Modigliani and Miller, 1958)
In the second proposition of the same theory, weightage is given to the real world conditions.
In simple words, the presence of the tax shield leads to the reduction in the sensitivity or the
volatility in the cost of the capital. This leads to the observation of a relationship between the
cost of equity and the level of leverage. However, there is also a chance of default in the debt
instalments, with each addition in the debt portion. The second preposition is reduced to
formula as below.
.
(Source: Modigliani and Miller, 1958)

It can be concluded that the borrowed funds lead to the value addition to the extent the cost of
achievement of tax benefits is lower in contrast to the cost of bankruptcy.

References
Ahmeti, F. and Prenaj, B. (2015) A critical review of Modigliani and Miller’s theorem of
capital structure. International Journal of Economics, Commerce and Management (IJECM),
3(6).
Ani, G. (2016) “Dividend irrelevance theory” [online]
https://www.dividend.com/dividendeducation/dividend-irrelevance-theory/ [Accessed on:
11/04/2020].