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What is Modigliani and Miller Approach?


Modigliani and Miller Approach: According to this approach change in leverage in capital structure does not change in value of the firm. If debt increases in capital structure or decreases in capital structure, it does not make any changes in value of the firm.

Assumptions of Modigliani and Miller Approach:
·         There is no corporate tax.
·         There is a perfect capital market.
·         The investors are rational.
·         There are no retained earnings.

Formula:
V = (EBIT / Ko)*(1-t)
V = Value of the firm
EBIT = Earnings before interest and tax
Ko = Overall cost of capital or weighted average cost of capital
T = tax rate

Example: Find out the value of the firm with the help of following information:
Particulars
Amount (in Rs.)
Earnings before interest and tax
 1,20,800
Tax rate
40%
Weighted average cost of capital
8%
9% debenture
5, 00, 000

Solution: V = (EBIT / Ko)*(1-t)
= (1, 20, 000 /0.08)*(1-0.40)
= 15, 00, 000*0.60
V = Rs. 9, 00, 000

Example: Company X has 7% debenture of Rs. 90,000. The earnings before interest and tax are Rs. 1, 60, 000. The market value of equity is Rs. 1.60 per share. The total number o f shares are issued by company X is 50, 000. There is another company P who didn’t issue any debt to raise capital. The earnings before interest and tax are Rs.1, 60, 000. The numbers of share issued by company P is 70,000. The market value of shares is Rs.1.20 per share. Mr. Mehta holding 8% shares in company X. You have to find out if Mr. Mehta switching his holdings to Company P is better for him or not? (With the help of Modigliani and Miller Approach)

Solution: Due to different capital structure, their market value of shares is different to eliminate this process arbitrage process is used in which undervalued stocks are purchased and overvalued stocks are sold out and personal leverage are used against corporate leverage.
Mr. Mehta holding 8% shares in Company X and if he is switching his holdings to Company P then:
Total number of shares Mr. Mehta holding in Company X = 50, 000*8/100 = 4000
He will sell his shares of company X in market = Rs. (4000*1.60) = Rs. 6, 400
Now he raise a loan   = 90,000*8/100 = Rs. 7,200
The total cash Mr. Mehta receives are Rs. (6, 400+7, 200) = Rs. 13, 600
The total number of shares invested in company P is 11, 333 (13, 600 / 1.20)
So, Mr. Mehta holds 16.19% shares in Company P (11, 333/70,000)
So, the total income of Mr. Mehta is:

Company X:
Particulars
Amount (in Rs.)
Earnings before interest and tax
1, 60, 000
Less: Interest
20, 300
Earnings available for shareholders
1, 39, 700
Mr. Mehta share in profit 8%
11, 176

Company P:
Particulars
Amount (in Rs.)
Earnings before interest and tax
1, 60, 000
Less: Interest
------
Earnings available for shareholders
1, 60, 000
Mr. Mehta share in profit 16.19%
25, 904
Less: 7% Interest paid on loan
504
Net income
25, 400

It shows that the net income of Mr. Mehta in Company P is more than the net income in Company X. So, it is good for Mr. Mehta for switching his holdings to Company P from Company X.



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