Discuss M & M preposition I of capital structure

The Modigliani and Miller (M&M) Proposition I is a theory that states that in a perfect and efficient market, the value of a firm is independent of its capital structure.

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In other words, the market value of a firm is determined by its operating income and the risk of its assets and operations, and not by how it is financed.

The M&M Proposition I assumes that there are no taxes, bankruptcy costs, transaction costs, or agency costs in the market. It also assumes that investors have access to the same information and can borrow and lend at the same rate. In such an ideal market, the cost of equity and the weighted average cost of capital (WACC) of a firm remain constant, regardless of its capital structure.

According to the M&M Proposition I, the value of a firm can be calculated using the following formula:

V = EBIT / r

where V is the value of the firm, EBIT is the earnings before interest and taxes, and r is the required rate of return on the firm’s assets.

The M&M Proposition I has important implications for financial decision-making. For instance, it implies that firms cannot create value by changing their capital structure. In other words, increasing the debt-to-equity ratio may lower the cost of capital and increase the return on equity, but it will not increase the overall value of the firm.

However, in the real world, the M&M Proposition I assumptions do not hold true. There are taxes, bankruptcy costs, transaction costs, and agency costs that affect the market value of a firm. As a result, the M&M Proposition I provides a theoretical framework but may not be applicable in practice.

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