Literature Review Of M & M Theorem

Decent Essays
Literature review
The collaboration between the university professors and Nobel Prize winners, Franco Modigliani and Merton Miller in 1958 have resulted the first and one of the most important theories in the field of capital structure. Franco Modigliani and Merton Miller (MM) have developed a theory that helps us to understand how taxes and financial distress affect a company’s capital structure decision. There were different unclear issues that M&M theorem used their basis in building their assumption. For instance, would a change in financing mix increase the value of a company. There were many other issues taken into consideration which result the two main assumptions as well as there were many other assumptions added in the coming years after the M&M propositions, which have tried to complement
…show more content…
Hence, before M&M theorem there were no generally an accepted theory (Luigi & Sorin, 2011, p. 315). Modigliani and Miller start by assuming that the firm has a particular set of expected cash flows. Once the company decides to finance its assets, by selecting a certain proportion of debt and equity, all it does is to split the cash flows between investors. Based on the assumption taken into consideration by Modigliani and Miller that the investors and firm have equal access to financial markets, which allows them for homemade leverage. The authors also pointed out that the investor can create any leverage they wanted but not offered or the investor can get rid of any leverage that the firm took on but was not wanted. This theory was proposed under perfect capital market conditions (without taxes, transaction costs and information asymmetry) value of any firm is independent of its financing decisions (Modigliani and Miller 1958). In a simplified context, the value of the firm will not be affected by the leverage of the
Get Access