What is the difference between CAPM model and Modigliani Miller Model?

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is an extension of portfolio theory, where adding more share to a portfolio means that your overall risk and return approaches market risk and return. All stock market s have an ‘average’ risk and this cannot be diversified away by adding more and more shares. This theory adds extra theory to portfolio theory:

·         The possibility of risk-free assets which carries no risk for investors, for example government bond;

·         All investors have identical expectations and view on risk.

The risk-free rate is usually cited as a government bond or undoubted debt. The market return minus the risk-free rate represents the risk premium. Investors can either accept no risk with a low rate or alternatively, through a diversify portfolio, earn a market return with increased risk. By accepting risk, the overall returns could be better or worse.

 Financial Leverage And Capital Structure Policy - Modigliani And Miller's Capital Structure Model

Modigliani and Miller, two professors in the1950s, studied capital-structure theory intensely. From their analysis, they developed the capital-structure irrelevance proposition. Essentially, they hypothesized that in perfect markets, it does not matter what capital structure a company uses to finance its operations. They theorized that the market value of a firm is determined by its earning power and by the risk of its underlying assets, and that its value is independent of the way it chooses to finance its investments or distribute dividends.

The basic M&M proposition is based on the following key assumptions:

• No taxes
• No transaction costs
• No bankruptcy costs
• Equivalence in borrowing costs for both companies and investors

Symmetry of market information, meaning companies and investors have the same information

No effect of debt on a company's earnings before interest and taxes

Of course, in the real world, there are taxes, transaction costs, bankruptcy costs, differences in borrowing costs, information asymmetries and effects of debt on earnings. To understand how the M&M proposition works after factoring in corporate taxes, however, we must first understand the basics of M&M propositions I and II without taxes.