Modigliani and Miller Hypothesis
The Modigliani and Miller (M–M) Hypothesis is identical with the net operating income approach. M-M approach argue that in the absence of taxes, a firm’s market value and cost of capital remain invariant capital structure changes. In their article published in 1958, they gave the behavioural justification in favour of their hypothesis under certain assumption.14
M-M propositions are based upon certain assumptions. These assumptions relate to the behaviour of investors. Capital market, tax environment.
(1) The securities are traded in a prefect capital market situation. This especially means :-
(a) Investors are free to buy and sell securities.
(b) Borrow without restriction on the same terms as firms do.
(c) Investors are rational there are no transaction cost.
(2) Firms can be grouped into homogeneous risk classes Firms would be considered to belong to a homogeneous risk class if their expected earnings have identical risk characteristics.
(3) The average expected future operating earnings of a firm are represented by subjected random variable. It is assumed that expected value of the probability distributions of all investors of expected operating earnings for all future periods are the same as present operating earning.15
(4) Absence of corporate taxes is assumed. M-M remove this assumption later on.