Critique on Mm Theory

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American economist Franco Modigliani and Merton H. Miller published The Cost of Capital, Corporation Finance and the Theory of Investment (Hereafter MM theory); a paper presented the initial MM theory, which states that under a certain market price process, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm 's capital is raised by issuing stock or selling debt. It does not matter what the firm 's dividend policy is (Modigliani and Miller 1958). The basic assumptions of MM theory are: 1. The company only has the long-term bonds and common stocks, both bonds and stock trade in the complete capital…show more content…
That is, the higher corporate income tax rate, the more tax deductible the corporation could achieve from financing by liability. In other words, corporations are inclined to finance by liabilities rather than equity financing in relative higher corporate income tax rate countries, and vice versa. Under the actual situation in China, the corporate income tax is much higher than other countries in the world; corporations should prefer financing from debt theoretically (Huang and Zhang 2007). However, actually, the capital structure of Chinese enterprises runs counter to the MM theory and other capital structure theories. The proportion of liability financing in China is far less than the proportion of equity financing (Huang and Song 2006). First of all, there is merely no mechanism in applying MM theory. In accordance with the MM theory, both individual and institutional investors can process arbitrage actions freely in the capital markets. In western well-developed capital markets, there is a wide range of fund-raising channels and other financing options, the arbitrage mechanisms usually affect the markets. However, at present, the market mechanism is not fully developed in China, as well as capital market is under-developed. Thus, these limit the financing options and forms; make it difficult to carry out arbitrage activities. Generally, MM theory cannot be applied. Secondly, the tax-saving of MM theory affects gently in China. As the
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