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. Modigliani and Miller (1963) adjusted the theory by adding company tax and adjusted again by Miller (1977) by adding personal tax in the theory. After including company and personal tax in the theory, the interest payments made from debt by the firm will be tax deductible and it will reduce the income tax for the firm. According to Eriotis et al., (2007), the tax shield would let the firm to pay lower taxes when it use its debt than when …show more content…
Therefore, if a company adopts the Modigliani and Miller theory, it would not be able to determine a firm’s capital structure appropriately. And the firm would not be able to measure its correct value, and the correct WACC. Also, the stock price of the firm would not be appropriate. The Modigliani and Miller theory ignores the company tax and personal tax and it also ignores personal sector of financing with retained earnings. In reality, firms do not give out the whole amount of retained earnings in form of dividends. Also, investors would not be very interested in buying low priced shares issuing by highly geared
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.
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.
The mixture of debt-equity mix is important so as to maximize the stock price of the Costco. However, it will be significant to consider the Weighted Average Cost of Capital (WACC) as well so that it can evaluate the company targeted capital structure. Cost of capital (OC) may be used by the companies as for long term decision making, so industries that faced to take the important of Cost of capital seriously may not make the right choice by choosing the right project(Gitman’s, ).
At first, WACC and CAPM was attempted to be used as a source of cost of capital. However, for WACC, there is no available proportion of debt and cost of debt for MW. For CAPM, no available data seems to support the acceptable
What role does the tax deductibility of interest play in encouraging debt financing at CPK?
The effect of financial leverage on the cost of equity is prevalent in the Modigliani-Miller capital structure theory. Since the financial leverage increases the cost of equity, it can be considered one of the disadvantages of borrowing. As shown in Appendix A, the cost of equity, at each debt to capital ratio, increases by 0.1% as the financial leverage increases by 10%. With a higher
managers may not directly set the cost of capital, they play a large role in determining the capital structure
a) Weighting of Capital Structure: Use of book values of capital rather than the market values
Generally, firms can choose among various capital structures in order to maximize overall market value of the company. It is proposed however, that
According to the Equilibrium Theory, a company has reached its optimal capital structure when it minimizes the total sum of taxes paid and the cost of financial distress. Taxes paid and the costs of financial distress develop in opposite directions as the interest coverage ratio (EBIT/interest) changes. While the tax shield effect and thus the amount of taxes paid at different coverage ratios can easily be calculated using the marginal tax rate (in the case of Diageo 27%), the cost of financial distress has to be approximated using sophisticated financial models (e.g. Monte Carlo Analysis) that take into account probabilities of different direct and indirect costs of financial distress.
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
Franco Modigliani and Merton Miller examined how a corporation should select securities to sell in order to attain an optimal mix between debt and equity, the mirror image of what Markowitz and Tobin had studied. Their findings led them to the conclusion that the market value of a firm is independent of its capital structure. In an efficient market, the market will place the same value on firms with equal earnings power and equal risk. Their most innovative contribution to the theory of finance was in elevating arbitrage to the level of a driving force. This Law of One Price states, “two assets with identical attributes should sell for the same price… a profitable opportunity will arise to sell the asset where it is overpriced and to buy it back when it is underpriced. The arbitrager will then lock in a sure profit, otherwise known as a free lunch.” (171) In effect, arbitragers actually fix the imperfections in the market by bidding away the
The advantage of debt financing is that interests paid on such debt are tax deductible. If a company has the intention of maintaining a permanent debt, the present value of the tax shield can be obtained by discounting them by the expected rate of return demanded by the investors who hold the debt (this is a perpetuity, where in reality would be the maximum possible present value for the tax shield). This tax shield value reduces the tax bill and increases the cash payment to investors, increasing the value of their investments.
The trade-off theory of capital structure refers to the suggestion that a business chooses the
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).