Modigliani and Miller ApproachModigliani and Miller approach states that the financing decision of a firm does not affectthe market value of a firm in a perfect capital market. In other words MM approach maintainsthat the average cost of capital does not change with change in the debt weighted equity mixor capital structures of the firm.Modigliani and Miller approach is based on the following important assumptions:• There is a perfect capital market.• There are no retained earnings.• There are no corporate taxes.• The investors act rationally.• The dividend payout ratio is 100%.• The business consists of the same level of business risk.Value of the firm can be calculated with the help of the following formula:−oEBIT (l t) KWhereEBIT = Earnings before interest and tax Ko = Overall cost of capital t = Tax rateCapital Structure 59 KeKokD/ERisk Due D ebtRisk Bearing DebtRate of ReturnFig. 5.2 Modigliani and Miller ApproachExercise 6There are two firms ‘A’ and ‘B’ which are exactly identical except that A does not useany debt in its financing, while B has Rs. 2,50,000 , 6% Debentures in its financing. Boththe firms have earnings before interest and tax of Rs. 75,000 and the equity capitalizationrate is 10%. Assuming the corporation tax is 50%, calculate the value of the firm.SolutionThe market value of firm A which does not use any debt.Vu=oEBITK= 75,00010/100 =75,000×100/10= Rs. 7,50,000The market value of firm B which uses debt financing of Rs. 2,50,000Vt = Vu + tVu = 7,50,000, t = 50% of Rs. 2,50,000= 7,50,000 + 1,25,000= Rs. 8,75,000


Comparative profit and loss account analysis
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