Modigliani and miller theory — OpenTuition Forums

Rrimx13y ago

Hey John,
In this theory we assume that investors are indifferent between corporate gearing and personal gearing, i couldn't understand this assumption can you please elaborate it to me also in relation to ignoring fear of bankruptcy.

Looking forward to hearing from you.

John MoffatTutor13y ago#1

In their proof, they compare owning share in a geared company with owning share in an ungeared company.
Obviously the risk is different, because the geared company is paying interest and the ungeared is not.
To make them the same, they have the person investing in the ungeared company borrow some money so that he himself is paying interest.
(However do not worry too much about this because the proof of M&M is not in the syllabus)

The only risk M&M consider with regard to gearing is the fact that fixed interest is payable each year. This makes the dividend stream more risky (changes in the profit before interest will mean bigger changes in the profit available for shareholder). They ignore the risk of the company going bankrupt.