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summary of modigliani and miller articleon capital structure
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Does the capital structure of a firm really matter? If so, how and why does it matter? Practitioners and scholars of corporate finance have debated these questions for several years and have found it difficult to come up with definitive answers. The classical work of Modigliani and Miller (1958) provided the impetus for what is now, orthodox corporate finance theory on the optimal capital structure of firms. They postulated that, in a perfect or frictionless capital market, the choice between debt and equity financing has no material effect on the value of the firm. Stern and Chew (2003) noted that following the Modigliani-Miller propositions, academic researchers in the 1960s and 1970s turned their attention to market imperfections that might make firm value depend on capital structure. They further noted that the main suspects were a tax code that encourages debt by making interest payments but not dividends tax-deductible and expected costs of financial distress that rise with increasing amount of debt. Towards the end of the 1970s, they noted, there was also discussion of signalling effects, such as the tendency for stock prices to fall significantly on the announcement of new equity issues and to rise on the news of stock buyouts. These effects seemed to confirm the existence of large information cost that could influence financing choices in the predictable ways.Myers (1984), however, noted that there is a conflict which has existed among the different theories and referred to is as the “capital structure puzzle.” Barclay and Smith (2005) noted that it has been the difficulty of coming up with conclusive tests of the competing theories. Firstly, they noted that model on capital structure typically are less precise than... ... middle of paper ... ...there may some problems. They noted that in such estimation technique, some of the variables in the equation were likely to be simultaneously determined with the dependent variable or the other explanatory variables. They recommend that Instrumental Variables (IV) techniques be used to carry out studies of this nature. This study will compare the results of the traditional panel data techniques with those of the instrumental variable techniques. The remainder of this paper will be organized as follows: Chapter 2 introduces the review of both the theoretical and empirical literature. Chapter 3 explains and develops the method which is employed in this study. Chapter 4 gives an analysis of the data used in this study and the empirical results. Finally, in Chapter 5, the conclusions of this study are presented along with policy recommendation on firm financing.
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.
The consistent high spending of capital equipment is the first reason why one would recommend reducing the debt to equity ratio. A company with higher levels of debt is less flexible in being able to adjust to new market demands and conditions that require the company to make new products or respond to competition. Looking at the pecking order of financing, issuing new shares to fund capital investing is the last resort and a company that has high levels of debt, must move to the equity side to avoid the risk of bankruptcy. Defaulting on loans occur when increased costs or bad economic conditions lead the firm to have lower net income than the payments on loans. The risk of defaulting on loans and the direct and indirect cost related to defaulting lead firms to prefer lower levels of debt. The financial distress caused by additional leverage can lead to lower cash flows available to all investors, lower than if the firm was financed by equity only. Additionally, the high debt ratio that Du Pont incurred also led to them dropping from a AAA bond rating to a AA bond Rating. Although the likelihood of not being able to acquire loans would be minimal, there are increased interest costs with having a lower bond rating. The lower bond rating signals to investors that the firm is more likely to default than if it had a higher (AAA) bond rating.
Different management attitudes bring about varying capital structures. Management are conservative or aggressive depending upon their outlook on risk. Both management styles exercise different judgments. In the case of Johnson and Johnson management are conservative and use less debt, whereas management with an aggressive approach is more likely to use debt to grow profits.
In this chapter there were presented three basic discounted cash flow methods for firm valuation that are often used in practice and which explicitly or implicitly include the value of the tax shield of debt. It should be mentioned, as Bertoneche and Federici (2006) and Fernandez (2007a) prove, that the different valuation methods give the same result for total value of the firm as well as for the value of the tax shield of debt, as long as the valuation methods rely on the same hypotheses and do not implicitly include any additional assumptions. Indeed, Fernandez (2007a) notes: “This result is logical, as all the methods analyze the same reality under the same hypotheses; they differ only in the cash flows taken as a starting point for the valuation.”
Parrino, R., Kidwell, D. S., & Bates, T. W. (2011). Fundamentals of Corporate Finance. Hoboken, NJ: John Wiley & Sons. (Original work published 2009)
The form of the additional capital funding (i.e. equity vs loan) has no tangible impact on SJKII and Fosun’s voting power since Fosun and SJKII are the majority shareholders and the debtors.
The market value is not affected by the firm’s capital structure, that’s what the M&M first proposition stated; in proposition one it is stated that under certain conditions the firm’s debt equity has got no effect on the firm’s market value. This approach is based on the below:
During the last few years, Harry Davis Industries has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that had been proposed by the marketing department. Assume that you are an assistant to Leigh Jones, the financial vice president. Your first task is to estimate Harry Davis’s cost of capital. Jones has provided you with the following data, which she believes may be relevant to your task.
The source of asymmetric information is the manager-investor relationship, because, while managers can be assumed to have in-depth knowledge of the firm they are running whereas investors are unknown to the internal information of the company. For example, A and B are the potential buyer and seller of shares of company XYZ. If the seller knows the one of the manager in the company and has heard that the company is facing undisclosed financial problems, then the seller has asymmetric information. The capital structure decision, taken by managers, may then work as an indication to communicate insider information to external investors. Management often utilise the information to increase their own wealth, whereas, outside investors do not have access to that information. Managers learn how and when to make maximum profits from control of the firms’ operations which may establish them and pursue self-serving actions at the expenses of shareholders. Due to information asymmetry, shareholders do not have adequate information to assess if managers have satisfied their contractual
According to Howe and Shilling (1988), REITs is required to have a 100% equity capital structure if there is absence of tax deductibilty. It means it will be too expensive to issue debt and they will be at a economical disadvantage if REITs have to compete for debt funds against non-REIT firms that receive the tax benefit of debt. However, Jaffe (1991) disagree with this statement. He shows that for REITs, capital structure irrelevance does indeed hold, theoretically following the original Modigliani and Miller (1958) irrelevant proposition.
In the present business environment, organizations need adequate funds so as to operate effectively and efficiently. The financial strength of an organization enables them to have a competitive advantage over their competitors. Since most organizations main aim is profit maximization, all their activities are geared towards raising of funds. Organizations should therefore engage in activities that increase their income. There are several activities that organizations engage in with an aim of funds generation (About.com, 2011).
While Bhide (1990) suggests that the difference lies in the dealings of customers, suppliers, lenders, and tax authorities with the diversified firm are affected by the aggregated fortunes of its constituent businesses and the additional level of administrative or corporate overhead, we see that there are three main reasons for diversification. First, Lewellen’s financial theory of corporate diversification (1971) argues that diversification at the firm level leads to a reduction in variance of future cash flows thus increasing the debt capacity of the diversified firm. He concludes that as long as debt capacity adds value, diversification is a source of added value. Secondly, diversified firm’s cash flows provide a superior means of funding an internal capital market which offers a number of possible sources of value to the firm’s owners as internally raised equity capital is cheaper than funds raised in the external capital market and this gives the firm’s managers superior decision control over project selection, rather than forcing them to base the firm’s investment decisions to perceptions less-informed investors in the external capital market. This was formally put forth by Stein (1997), who suggests that managers select better projects as they have superior information. Finally, Khanna and Palepu (1999) propose
The capital structure of a firm is the way in which it decides to finance its operations from various funds, comprising debt, such as bonds and outstanding loans, and equity, including stock and retained earnings. In the long term, firms seek to find the optimal debt-equity ratio. This essay will explore the advantages and disadvantages of different capital structure mixes, and consider whether this has any relevance to firm value in theory and in reality.
The optimum size of a firm is a very subjective idea. The ways in which
Mayer, C. (1990). Financial Systems, Corporate Finance, and Economic Development. In R. G. Hubbard, Asymmetric Information, Corporate Finance, and Investment. Chicago: University of Chicago Press.