Which of the following are assumptions underlying MM Theory of capital structure?

A. Perfect Capital Market

B. Heterogeneous Expectations

C. Absence of Taxes

D. 100% Dividend Payout

E. Equivalent Risk Class

Choose the correct answer from the options given below:

Correct option is D

The Modigliani-Miller (MM) Hypothesis, introduced in 1958, is a cornerstone of modern corporate finance which argues that under certain conditions, the value of a firm is independent of its capital structure (Irrelevance Theory). The original MM model is built on several restrictive assumptions to ensure that the arbitrage process works perfectly. These include:

1. Perfect Capital Markets: Investors are free to buy/sell, there are no transaction costs, and they behave rationally.

2. Absence of Taxes: In the initial 1958 paper, it was assumed that there are no corporate or personal income taxes.

3. 100% Dividend Payout: Firms distribute all their net earnings to shareholders, meaning there are no retained earnings.

4. Equivalent Risk Class: Firms can be grouped into "homogeneous risk classes," where all firms in a class have the same degree of business risk.

5. Homogeneous Expectations: All investors have the same expectations regarding a firm's future Net Operating Income (EBIT).

Therefore, statements A, C, D, and E are correct assumptions, while B is incorrect because MM assumes Homogeneous (not Heterogeneous) expectations.

Information Booster

• Arbitrage Process: This is the behavioral justification for the MM theory. If two firms are identical in all respects except for leverage, and they have different values, investors will sell the overvalued firm's shares and buy the undervalued firm's shares (using personal leverage), until prices equalize.

• Proposition I (No Taxes): States that the value of a levered firm (V_L) is equal to the value of an unlevered firm (V_U).

• Proposition II (No Taxes): States that the cost of equity increases linearly with the debt-equity ratio, exactly offsetting the benefit of cheaper debt, keeping WACC constant.

• Relaxation of Assumptions: In 1963, MM relaxed the "No Tax" assumption, acknowledging that interest is tax-deductible, which makes debt financing advantageous and increases firm value.

• Homemade Leverage: MM assumes that individuals can borrow at the same rate as corporations, allowing them to replicate corporate leverage on their own.

Additional Information

• Heterogeneous Expectations (Option B): This term refers to a situation where different investors have different views or "expectations" about the future performance of a firm. In the MM model, this is specifically rejected in favor of Homogeneous Expectations to ensure that all investors value the firm's EBIT identically.

• Transaction Costs: MM assumes these are zero. In the real world, brokerage, legal fees, and flotation costs make the arbitrage process less efficient.

• Risk Class: While MM assumes Equivalent Risk Classes (meaning firms in the same industry have the same risk), in reality, even firms in the same industry have different operational risks due to technology, management, or scale.

• Personal vs. Corporate Debt: The theory assumes these are perfect substitutes. However, in reality, individuals usually pay higher interest rates than corporations and have limited liability protection, making "homemade leverage" riskier than corporate leverage.