Miller and Modigliani Theory

By Bobby Shan

January 13, 2011

There was not any accepted theory on capital structure before 1958. Miller and Mongolian (1958) explained that firm's value didn't vary by any change occurred in the capital structure. The contemporary theory was specified by Miller and Mongolian (1958) who proved that there was not any effect of financing on firm's value. Total cash flows Firms build for investors unaffected despite the consequences of capital structure. In other words, shifting the debtequity combination didn't bring any change in the total cash flows of firms. As a result, the overall assets' value presented possession of such cash flows which didn't change.Myers (2001) described that weighted average cost of capital (WACC) depending on cost of equity and cost of debt and also market value ratios of equity and debt to firm value. Miller and Mongolian (1963) recognized the effect of taxes by using assumption of none corporate tax and in this way corporations were permitted to deduct interest in the form of expense. Modigliani and Miller (1963) recognized that net of tax approach encouraged the firms to utilize 100 percent debt in debt-equity combination but Modigliani and Miller (1963) discouraged 100 percent debt policy. Some other sources were also there to generate the funds at lower costs like retained earnings. In some conditions, retained earnings may be cheaper even tax status of shareholders under the personal income tax also considered.Modigliani and Miller (1958) gave an idea about that the value of the firm did not change when any change occur in the capital structure. Firms build total cash flows for all investors were unchanged despite the consequences of firm financing. Altering the finance alternative did not amend the total cash flows. Consequently the overall assets' value provided ownership of these cash flows should not change. MM argue if worth of the firm depends on capital structure; which may be resulted in arbitrage opportunity in the perfect capital market. In addition, these decision counteracted when investors and firm had access to at same rate. Despite the fact that MM theory was stands on numerous impractical assumptions, yet it presented the essentials theoretical background for further research.Financing alternatives elucidated when disparity in information had available to stockholders and stranger regarding the investment opportunities and income allocation of the firm. This information parity

consequence in two separate results for alternatives, it was known as signaling with percentage of debt. Ross (1977) contributed that manager always familiar about the financial position of the company and its return allocation. When executives take debt decisions, it produce affirmative signal to stakeholders; about the financial position of the organizations and its ability to retire its debts and truthful allocation of return of the company. Myers and Majluf (1984) stated that shareholders always think executives employed confidential information when they offer risky securities and also overpriced securities. This observation guided under pricing of fresh equity offerings, this was also resulted in significance loss of present shareholders. For these reason organizations away from offering new projects through equity financing and used its internal funds if further financing was required firms issued debt last option is equity financing

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Capital Management Tactics in Corporate Finance

By Daisey Brown

January 31, 2011

Lower debt finance should be used while to avoid facing threat of bankruptcy. The use of debt finance must be based on earning in terms of present value. It is important to analyze the past and present record of the firm with accurate finance resources. The capital structure must focus on market values. With the help of an effective capital structure it is possible to maximize the market value of the firm. The credibility of the firm mainly depends on the market value. With proper capital management it is possible to use the resources effectively to yield better return on investment Article Source: http://EzineArticles.com/5805239

Review of the Literature Modigliani and Miller (1958) claim that under perfect capital market conditions, a firm s value depends on its operating profitability rather than its capital structure. In 1963, Modigliani and Miller (1963) fix the previous paper; argue that, when there are corporate taxes then interest payments are tax deductible, 100% debt financing is optimal. This means that the firm s value increases as debts increases. Titman (1984) demonstrates the idea of indirect bankruptcy costs. He argues that stakeholders not represented at the bankruptcy bargaining table, such as customers, can suffer material costs resulting from the bankruptcy. Leland (1994) demonstrates a standard trade-off model. At the optimal capital structure, marginal bankruptcy costs associated with firms debt are equated with marginal tax benefits. The static

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tradeoff theory was the original retort to the theory of capital structure relevance. Modigliani and Miller (1963) argue that, when there are corporate taxes then interest payments are tax deductible, 100% debt financing is optimal. In this framework, firms target an optimal capital structure based on tax advantages and financial distress disadvantages. Firms are thought to strive toward their target and can signal their future prospects by changing their structure. Adding more debt increases firm value through the markets perception of higher tax shields or lower bankruptcy costs. But optimal capital structure at a 100% debt financing are clearly incompatible with observed capital structures, so their findings initiated a considerable research effort to identify costs of debt financing that would offset the corporate tax advantage. Since then, extensions of the Modigliani-Miller theory have been provided by the following researches. Robichek and Myers (1965) argue that the negative effect of bankruptcy costs on debt to prevent firms from having the desire to obtain more debt. Jensen and Meckling (1976) identify agency cost in governing the corporation. The general result of these extensions is that the combination of leverage related costs (such as bankruptcy and agency costs) and a tax advantage of debt produces an optimal capital structure at less than a 100% debt financing, as the tax advantage is traded off against the likelihood of incurring the costs.