1) Analyze and discuss the following proposition by Franco Modigilani and Merton Milles (MM): "...when there are no taxes and the capital markets are functioning well, the market value of a company does not depend on its capital structure. In other words, financial directors cannot increase value by changing the mix of securities used to finance the company Use hypothetical numerical examples to argue your point.

This MM theory of no taxes is about value of a company in an efficient market. If there are no taxes then company value is not dependent on the capital structure. The reason is debt interest payments are tax deductible, if there will be no tax then benefit of debt in the capital structure is zero, then if a company is financed with equity or debt it is no difference and valuation of the company is unchanged. Financial directors in this case in an efficient market cannot change the value of company by changing the capital structure because debt or equity does not make any difference in the absence of tax.

Example:

If a company has equity and debt 30% and 70% respectively then value of WACC of the company without taxes is same even if there is 50% equity and 50% debt ratio. Changing the ratios of debt and equity is irrelevant to company cost of capital.

A company named ABC has a market value of 200,000 with 50000 shares outstanding is considering to change its capital structure by borrowing 100,000 with repurchase of its shares. No taxes.

Value of share is 200,000/50000 = $4

To borrow 100000 company need to repurchase 25000 shares.

Value before repurchase:

Assets 200000

Equity 200000

Value after repurchase:

Assets 200000

Equity 100000

debt 100000

There are no taxes so, the value remains the same changing the capital structure is irrelevant in no taxes case.