The results obtained from the cooperation of Modigliani and Miller in 1958, was an attempt to prove that the financial decisions should not be significant in the perfect conditions of the market, after being published the Modigliani and Miller theory became the main theory of the capital structure. In the M&M theory it suggested that the market is fully efficient, meaning that there are no taxes, however in the theory Modigliani and Miller included the taxes to be able to reflect their theories in reality, and the theory also suggested that there are no bankruptcy costs. There are three propositions that were published by Modigliani and Miller which are: • Proposition 1: A firm’s total market value is independent of its capital structure. • Proposition 2: The cost of equity increases with its debt-equity ratio. • First Proposition: Irrelevance of the Capital Structure: 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: Capital Structure is perfect: Assuming that there are no costs applied, and the investors have the ability to buy and sell securities and they also have the knowledge of any change; no costs for buying or selling of securities for brokers for example. Modigliani and Miller’s assumption is that all of these capital market factors which is needed for trading of securities are all perfect. Modigliani & Miller applied their theories with two modules, one which doesn’t include the taxes and this is their first findings, and another one with taxes to make it more realistic. The First Proposition without
Hall, A. (2001, August). The Flat Income Tax and the Fair Tax Consumption Tax: A
See Exhibit C. CAPITAL STRUCTURE MCI's current capital structure is x% debt and y% equity. Their key ratios are a, b, and c. Comparing to other firms in the utilities industry they appear to be underutilizing (debt/equity). See Exhibit D for more information. Referencing the forecast there is expected to be an x% annual increase in net income which would support an increase in debt/equity and keep ratios within the range of other firms in the industry (see exhibit E)....
...e, Maxime, and Giuseppe C. Ruggeri. "Flat Taxes And Distributional Justice." Review Of Social Economy 56.3 (1998): 277-294. Business Source Premier. Web. 19 Jan. 2014.
The higher the bid, the higher the debt would lead to a bigger debt and lesser profits for the owners of the firm. One of the six accounting principles that was discussed in the book was the expense principle, which helps determine the performance of a company by measuring the outflows and inflows of resources. The matching principle guides the recognition of expenses, so good matching will ultimately lead to a better measure of performance. When KKR exercised due diligence on RJR Reynolds, they could not figure out “other uses of cash” in the statements obtained. “The initial projections they had obtained from RJR Nabisco were heading towards ‘other uses of cash.’
...Although this theory is very rational and scholarly it again asks for a very ideal situation of fairness where the chances of both disputants coming to these terms seems unattainable. Also, it is quite obvious that what one sees as fair, another may not. All the same, the theory by itself provides great principles for negotiation that if followed honestly by both parties would most likely lead to a satisfactory agreement.
Having a low P/E ratio with respect to the rest of the market, and the replacement cost of the firm being greater than its book value (argument 3), there is a good chance that the current stock price and the proposed offering price are too low. Although long-term debt is a better financing choice, a few of the drawbacks are pointed out. Debt holders claim profit before equity. holders, so the chances that profits may be lower than expected. increases risk to equity, may reduce or impede stock value. However, the snares are still a bit snare.
Discussion of availability of theories in real world Many theories such as the dividend irrelevance, tax and clientele effects and information content and signalling effects are controversial in financial studies. Economists often argue whether they are applicable and reliable in reality. Miller and Modigliani’s (1961) dividend irrelevance theory is the typical one. MM suggested shareholders are indifferent to the changes in dividend policy in the company.
Higher leverage is very likely to create value for a firm considering capital structure change by exerting financial discipline and more efficient corporate strategy changes.
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.
There are perfect market conditions; no transaction costs, no taxes’ (Da, Guo and Jagannathan 2012).
The capital structure decisions for Target Inc. are significant since the profitability of the firm is specifically influenced by this decision. Profit maximization is part of the wealth creation process and wealth maximization can be a lengthy process for financial managers. Profits affect the value of the firm and it is expressed in the value of stock. Cost of capital is how investors evaluate weighted average cost of capital (WACC). Capital structure ratios help investors gauge the level of risk that a company is taking on through financing. While Target
In contrast, the Keynesian Economic Theory was presented in the 1930's, during the Great Depression, by a man named John Maynard Keynes (Classical vs. Keynesian). It relies on spending and aggregate demand which makes this theory demand driven. These economists believe that aggregate demand is influenced by public and private decisions. The public means the government, and the private means individuals and businesses. Aggregate demand sometimes affects production, employment, and inflation. When the economy starts to slack, they rely on the government to build it back up.
Efficient market hypothesis was developed by professor Eugene Fama at the University of Chicago Booth School Of Business as an academic concept of study through his published Ph.D. thesis in the early 1960s . Fama proposed two crucial concepts that have defined the conversation on efficient markets in his thesis. The efficient market hypothesis was the prominent theory in the 1960s, Fama published dissertation arguing for the random walk hypothesis to support his efficient market theory. “Fama demonstrated that the notion of market efficiency ...
In order to maximise firm value under this model, the firm should seek to borrow until that tax benefit from an extra £1 of borrowing equals the cost arising from increased likelihood of financial distress. It is clear that this theory regards the capital structure as highly relevent to firm value, and supports a real world scenario more strongly than M&M as it allows for bankruptcy costs. On an empirical level this perhaps explains why there are differences in capital structures between different
This paper will define and discuss five financial theories and how they impact business decisions made by financial managers. The theories will be the Modern Portfolio Theory, Tobin Separation Theorem, Equilibrium Theory, Arbitrage Pricing Theory (APT), and the Efficient Markets Hypothesis.