Can someone please explain the MM model with and without tax along with a example in a short and effective manner and the process of arbitrage (in hindi) for better understanding as i am left with other core subjects to revise and don’t getting time to watch Sanjay Sir’s last 2 videos of CS on Youtube. Thank you in advance
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This write up may help –
MM Model, Here it goes –
Capital Structure is all about Debt Equity Ratio of a firm and whether Debt is Good Or Bad
Everyone gave their own suggestions like – Debt Increases the risk in a firm or It reduces the Cost of Capital….
MM Makes entry and says – Debt Is Irrelevant
According to MM Model –
The value of a firm depends upon its ability to earn profits and not on its capital structure. There are two kinds of risk associated with every firm – Business risk and Financial Risk.
As per MM Model [In a no tax World] –
Firms belonging to the same risk class (Business Risk) will have the same Value irrespective of their Capital Structure (Financial Risk)
So, V(L) = V(U)
Q. 1 How to Compute Value of a firm ?
Ans 1 It is = Earnings of a firm / Kc. [Assuming No Growth]
Moreover, Kc for both the firms will be same.
Q. 2 How ?
Ans 2 – Because, In the levered firm Ke will rise on account of a rise in Financial Risk, But Debt (Kd) is cheap and thus their Weighted average Cost will be the same as that of Kc of an Unlevered Firm.
Now comes the Real World – Where Taxes Exist
In the real world, the WACC of a Levered firm will be less than that of Unlevered Firm because of Tax Advantage on Debt. This means that debt becomes more cheap and Kc falls.
[A bit Off Topic –
So, does that mean Debt is good – After all, if it reduces Kc then a firm should keep on taking debt ?
The answer is – Absolutely Not. We have to understand that we are doing MM Model which is based on multiple assumptions such as No Tax, No Growth etc.]
Back to the Real World –
Since the WACC of an Levered firm will be less – It has A Greater Valuation than the Unlevered firm – Unlike what happened in a No Tax World.
Q.3 Now what is the value of an Levered firm i.e V(L) in a world with Taxes ?
Ans – Earnings / Kc
Or V(U) + tB
Here, tB denotes the Tax Advantage of Debt.
That Forms the Basic of MM Model.
Sir used some notations while teaching –
Kc * – It is the WACC of an Unlevered Firm
In a No Tax World –
Kc* = Kc i.e. both the Levered and Unlevered Firm will have the same WACC.
But in A World with Taxes –
Kc will be less than Kc* because the levered firm will enjoy Tax Advantage on Debt.
I Hope this Helps.
Thank you Ayush.. 🙂