Challenge to Modigliani & Miller Model

As per Real Concept of Valuation Model:

"Increase in gearing level of a company will Decrease the value of business for share holders and there is no tax saving related with gearing."

This is based on the premises that real valuation of a company is based on the fact that it belongs to equity holders and value of capital employed has different perspective to value of business for share holders as a whole.

1. Behavioral Impact of Share Holders on Valuation
2. Net Operating value of Business for Share Holders

Hidden concept of valuation has been highlighted by above prepositions which shows that

• Increase in Gearing will result in decrease in value of business for share holders.
• WACOC will be fixed: increase in gearing level will not affect the WACOC provided PAT is equal to dividend.
• Value of tax for equity holders of Geared & Un-geared Company is same provided equity investment is same.

Debt holders have multiple protections for their Debt & interest not only on annual profits but also on assets of the company (in case of loss). This protection is provided by the Equity holders on the basis that in case of loss assets generated from equity funds can also be utilized for the payment of loan / interest. This extra protection results in decrease in value of geared company. The expected rate of return by equity holders shall be high due to these extra protections to Debt providers.