L1 - Modigliani & Miller (1958) ‘The Cost of Capital, Corporation Finance and the Theory of Investment’
The course project involved developing a great depth of knowledge in analyzing capital structure, theories behind it, and its risks and issues. Before I began this assignment, I knew nothing but a few things about capital structure from previous unit weeks; however, it was not until this course’s final project that came along with opening
This section starts with the theory of irrelevancy of capital structure. Following subsections give the overview of theories that suggest that the 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
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.
It seems then that companies should fully leverage the company or a least come close to doing so but there is a probability that the company enters financial distress as its leverage (D/E) increases. Financial distress can be very costly for companies, and the cost for this scenario is shown in the current market value of the levered firm's securities. Investors factor the potential for future distress into their assessment of the present value (this is where PV of distress costs is subtracted from un-levered company value and the PV of the tax-shield.) The value for the costs
Generally, firms can choose among various capital structures in order to maximize overall market value of the company. It is proposed however, that
Capital structure is the mixture of equity and debt finance used by the company to finance its assets. This terms created many issues around the decisions on how to have perfect capital structure for the firm to run well. Modigliani and Miller’s irrelevance theory is the most important and puzzling issues that have strong impact on the modern corporate finance theory and which is challenged the tradition optimal capital structure theory the most. After more than 50th years of existence, M&M is still one of the most controversy theory brought about many debates on the financing behavior of corporate in the business world. That is the reason for financial researchers and analysts consider this theory as a central financial concept for the study the capital structure decision. Along with this theory, the contribution of trade-off theory and pecking order theory to examine the optimal capital structure is contribute by other reaserchers.
There is no universal theory of the debt-equity choice, and no reason to expect one. In this essay I will critically assess the Pecking Order Theory of capital structure with reference and comparison of publicly listed companies. The pecking order theory says that the firm will borrow, rather than issuing equity, when internal cash flow is not sufficient to fund capital expenditures. This theory explains why firms prefer internal rather than external financing which is due to adverse selection, asymmetry of information, and agency costs (Frank & Goyal, 2003). The trade-off theory comes from the pecking order theory it is an unintentional outcome of companies following the pecking-order theory. This explains that firms strive to achieve an
Capital structure is defined as the mix of the long-term sources of funds that a firm use. It is composed of equity, debt securities and affect long-term financing of the entity. It is made up by shareholder’s funds, long-term debt and preference share capital. The capital structure mostly focus on the proportions of debt and equity displayed in the company financial statements, especially in the balance sheet (Myers, 2001). The value of a firm can be calculated by the sum of the value of its firm’s debt and equity.
i) The value of a firm is the same regardless of whether it finances itself with debt or equity. The weighted average cost of capital is constant. The assumptions of Modigliani- Miller theorem are; Perfect and frictionless markets, no transaction costs, no default risk, no taxation, both firms and investors can borrow at the same interest rate; there is homogeneous expectation homogeneous risk and equal access to all relevant information.
From this set of problems, we can see that leverage is good for the firm. Leverage has increased the value of the firm as a whole and increased the price per share. Although the cost of debt increases the firm's risk because it increases the probability of default and bankruptcy, therefore shareholders will require higher rates of return on the equity they provide, debt also provides tax savings. And we can see that in table 4, where we calculated the total value of the firm as the pure business cash flows plus the tax savings. Another reason why debt increases firm value is the fact that it reduces WACC, because the cost of debt is generally lower than the cost of equity. Another option that shareholders can do is using homemade leverage. Shareholders should pay a premium for the shares of a levered firm when the addition of debt increases value.
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).
The pecking order theory ( Donaldson 1961) of capital structure is among the most influential theories of corporate leverage. The pecking order theory is based on different of information between corporate insiders and the market. According to Myers (1984), due to adverse selection, firm prefer internal to external finance. If internal finance proves insufficient, bank borrowings and corporate bonds are the preferred source of external source of finance. After exhausting both of these possibilities, the final and least preferred source of finance is
The traditional theory of capital structure describes the existence of optimal debt to equity ratio, where the cost of capital is minimum and the market value of a firm is maximum. The changes in the financing mix can bring positive change to the value of the firm. Before the changes in the financing mix, the marginal cost of debt is less than cost of equity and after the change; the marginal cost of debt is higher than that of equity. This theory supports the combination of the equity and debt ratio of the capital structure of a firm when the market value is at its maximum. The debt in the capital structure of a firm can only be up to a certain point, any increase beyond that point can cause the increase in the leverage and can result in the decrease in the market value of a firm.