Which among the following is not an assumption of Modigliani and Miller theory of capital structure ?

Question

Accepted Answer

The correct option is 3:
The Modigliani-Miller (M\&M) theory of capital structure, particularly the original 1958 proposition, is built on a very specific, theoretical environment known as a **perfect capital market**. This perfect world must be free of the frictions found in reality. The assumption of a *Perfect Capital Market* is a cornerstone of the theorem, as it allows for 'homemade leverage'—the idea that investors can replicate the firm's capital structure on their own, making the firm's financing choice irrelevant to its overall value. An **Imperfect capital market** is the condition that M\&M *excludes* from their initial model. Since the question asks for what is *not* an assumption, the violation of the perfect market condition, which is an imperfect market, is the correct choice.

The incorrect option is 1:
**Homogeneous expectations** is a standard and necessary assumption for the M\&M propositions to hold. It means that all investors and managers possess the same information and agree on the future prospects and expected cash flows of the firm. Without this shared understanding, different investors would arrive at different valuations for the same firm, which would violate the core irrelevance principle.

The incorrect option is 2:
The **Absence of taxes** is a critical, explicit assumption of the original 1958 M\&M theorem. In a world without corporate or personal taxes, there is no financial advantage to using debt over equity because the interest paid on debt cannot be deducted to create a tax shield. The presence of a tax shield (which was introduced in the revised 1963 model) would make capital structure relevant, hence the *absence* of taxes is fundamental to the initial irrelevance theory.

The incorrect option is 4:
The assumption of **Rational Investors and Managers** is a prerequisite for the M\&M model. Rationality implies that participants act to maximize their expected wealth and will exploit any arbitrage opportunity that arises. It is the rational behavior of investors, specifically their ability to engage in "homemade leverage" by borrowing or lending on personal accounts, that is central to proving that a firm's market value is independent of its financial mix.