Analysis Of Modigliani And Miller 's Irrelevance Theory

Finding the perfect capital structure in terms of risk and reward can ensure a company meets shareholder expectations and protects a firm in times of recession. Capital structure refers to how a business puts its money to “work”. The two forms of capital structure are equity capital and debt capital. Both have their benefits and limitations. Striking that perfect balance between the two can mean the difference between thriving versus trying to survive.

c) Optimization of the capital structure is also consistent with the growth of the company. The optimal capital structure

As shown in the financial income statement (Exhibit3), Intel Corp. (INTC) has a capital structure consisting most of equity. Intel has very little debt in its capital structure and the cost of debt would have only a marginal effect on the overall cost of capital. The current capital structure of Intel is not optimal yet since optimal capital structure is making minimum weighted-average cost of capital.

Nevertheless, the use of the Optimal Capital Structure (OCS) is the right techniques to be used in order to acquire the right combination of debt and equity that can maximize the

Optimal Funding Terms: - An organization's proportion of short and long haul obligation ought to additionally be considered when analyzing its capital structure. Capital structure is regularly alluded to as a company's obligation to-value proportion, which gives understanding

Capital structure describes how a corporation has organized its capital—how it obtains the financial resources with which it operates its business. Businesses adopt various capital structures to meet both internal needs for capital and external requirements for returns on shareholders investments. As shown on its balance sheet, a company 's capitalization is constructed from three basic blocks:

While there are no hard and fast rules for optimizing a company’s capital structure, companies that are ahead of the curve use an efficient combination of senior debt, mezzanine debt, and equity capital to minimize their true cost of capital.

Effective financial management and what characters affect their capital structure are important for a firm to obtain better operational performance. A false decision about the capital structure may lead to financial distress and even to bankruptcy. There are numerous theories developed to analyze alternative capital structures. Among all these theories, the static trade off theory which derived by Modigliani and Miller (1963) was the earliest and most recognized which explains the formulation of capital structure. Their trade off theory assumed that there are optimal capital structures by trading off the benefits and cost of debt and equity. The main benefit of debt is tax deductibility of interest and the costs are bankruptcy

Modigliani - Miller (1958) theorem is considered the greatest breakthrough in theory of optimal capital structure. The theorem specifies the financial decisions by firms that are irrelevant to the firm’s value. Modigliani- It has four prepositions which are;

The Modigliani and Miller(1958) theory developed the proposition that in perfect markets, with absence of taxes, transaction costs, bankruptcy costs and asymmetric information, the value of the firm is not affected by how it is financed by its capital structure, also the weighted average cost of capital (WACC) will remain the same even if the firm's capital structure changes. For example, regardless of how much loan the firm borrows from its creditors, there will be no tax benefit gained from the interest payments it received, therefore there will be no changes made to the WACC. Since there is no benefit receiving from increases in debt, it means the capital structure does not affect a company's share price, thus the capital structure is unrelated to a company's share price.

Already in 1958, Modigliani and Miller have pointed the discussion of capital structure towards the cost of debt and equity. According to their first proposition, in a world of no corporate taxes and with perfect markets, financial leverage has no effect on a firm’s value. In their second proposition, they state that the cost of equity equals a linear function defined by the required return on assets and the cost of debt (Modigliani and Miller, 1958).

In the absence of tax, the M&M proposition I focus on the irrelevancy between the value and capital structure. The value of the levered firm must equal to the value of

There is need for them to therefore be familiar with capital structure theory as well as the benefits and drawbacks involved in the kind of method adopted in sourcing for funds.

In this part Modigliani & Miller stated that the firm’s value is not affected by the structure of the capital between Equity and Debt, They proved this by having an example of two firms that has got the same conditions in everything, same cash flow, same operational risks and same opportunity costs. One of the firm’s capital structure is all equity and the other firm’s capital structure is a mixture between equity and debt, since the form of financing (debt or equity) can neither change the firm’s net operating income nor its operating risk, the values of levered and unlevered firms will be the same.

Financial performance of firm and its value is greatly affected by the design of its capital structure. This issue is getting immense consideration after the MM,