This approach was devised by Modigliani and Miller during 1950s. The fundamentals of Modigliani and Miller Approach resemble that of Net Operating Income Approach.
Assumptions of MM models: MM models made the following assumption, some of which were later relaxed:
- Business risk can be measured by and firms with the same degree of business risk are said to be in a homogeneous risk class.
- All present and prospective investors have an identical estimate of each firm’s future EBIT (earnings before interest and taxes); that is, investors have homogeneous expectations about expected future corporate earnings and the riskiness of those earnings. This assumption implies Symmetric information wherein managers and all investors have the same set of information about a firm.
- Stocks and bonds are traded in perfect capital markets. This assumption implies, among other things, (i) that there are no brokerage costs, and (ii) that investors (both individual and institutions) can borrow at the same rate as corporations.
- The debt of firms and individuals is riskiness, so the interest rate on debt is the risk-free rate. Further, this situation holds regardless of how much debt a firm (or an individual) uses.
- All cash flows are perpetuities; that is, the firm is a zero growth firm with am “expectationally constant” EBIT, and its bonds are perpetuities. “Expectationally constant” means that investors expect EBIT to be constant, but, after the fact, the realized level could be different from the expected level.
The basic Modigliani-Miller models proposition is based on the following key assumptions:
- There are no taxes.
- No transaction costs, as well as bankruptcy cost, is nil.
- There is a symmetry of information.
- The cost of borrowing is the same for investors as well as companies.
- There is no floatation cost.
- There is no corporate dividend tax.
- No effect of debt on a company’s earnings before interest and taxes.