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Proving Modigliani and Miller Theories of Capital Structure: The Research on Indonesia’s Cigarette Companies

Modigliani and Miller theories, held as one of the most important theoretical compass for the world of Corporate Finance, has stated some aspects and measurements in which will determine one company’s step of heading towards financial decision of its capital structure. Modigliani and Miller themselves are revising their theorem until they created the second theorem of Modigliani and Miller, and also developing their theorem with the assumption of the existence of taxes, in which in the real world, we can’t deny that it exist. This paper is going to review and re-prove the MM theories in a research of three biggest public listed cigarette companies in Indonesia. Those companies are PT. Hanjaya Mandala Sampoerna Tbk., PT. Bentoel Internasional Investama Tbk., and PT. Gudang Garam Tbk. The analysis would be through the companies’ financial statement from the last 10 years, presented in a yearly basis of period. The reports are going to be compared with the two theorems made by Modigliani and Miller, both with and without tax assumption. As the result, it can be concluded whether the MM theorem works and is relevant for those three companies named above. By using the valuation and capital structure approach with several assumptions necessary to be made, the author has found out that the Modigliani Miller theories of capital structure do hold and are accurate for those given sample companies in representative to an industry. However, given different approach of measuring the cost of equity capital, the author found out that Modigliani Miller theories cannot adapt the cost of capital approach, but instead, go in line with the return on equity approach. Because of that, in some explanations of Modigliani Miller theories, the term cost of capital should not be written in the formulas, but instead, it should be written as the return on equity. The author also found some difference in calculation result between the research calculations and the MM theories, which is that the return on equity decreases as the leverage increase, while the MM theory stated that the return on equity should increase as the leverage increase, but that difference does not violate the theories, and they generally are still hold and valid. This happens because those factors have already been addressed as an exceptional condition in the MM theory, and it proves to be true that it has to be exceptional. Finally, the author addressed and concluded the factors that may lead inaccuracy in making calculations based on the MM theories, and the important assumptions to remember within this theory.