The Theory Proposed By Modigliani And Miller

3648 Words Aug 25th, 2014 15 Pages
Literature review
The theory proposed by Modigliani and Miller is also identical to operating income theory in the original proposition they proposed that in the absence of taxes, cost of capital and business value of the firm will not be affected by the capital structure changes.
The model introduced by Modigliani and Miller in their paper in 1958 has been come up as a challenged to all economists, scholars and researchers. But they have been struggling to answer the question pose by M&M model about tax benefit of leverage, by the time gone researchers gave many theories but they have not agreed upon one satisfactory result. So the purpose of the study will be to explain the main theories that contribute to the literature of capital
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To support all these assumptions there are three popular theories of capital structure available trade-off theory, pecking order theory and market timing theory.
The trade-off theory (TOT)

It is an important motivation for the trade-off theory of capital structure to explain how companies can usually be financed partly with debt and partly with equity. Trade-off theory States that there are benefits to finance debt tax shield benefits, mutual benefits, there are also debt-financing costs such as the costs of financial distress, agency costs. So the focus is maximizing its value to offset the costs versus the benefits of debt when deciding on the amount of debt and equity used to finance their work. Says Ross et al. (2008) can improve the company 's value at the point where the marginal cost is balanced and marginal benefits.

Tax Shield benefit

In the capital structure of the company, including debt reduction in tax liability of the company for the payment of interest on the debt, tax payment can even save all the interest Euro 0.35 (assume that the tax rate of 35 percent) to shareholders. This means that if the company with more debt in its capital structure, it must pay more and more interest can save more taxes for shareholders. This suggests a direct link between debt and taxes.

Agency benefit and distribution of the operating and business risk

Leverage plays vital
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