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Capital Structure: Modigliani & Miller’s Theory

Paper outline

Reasons why Modigliani & Miller’s propositions were initially misunderstood
Consequences of M&M propositions

Optimal capital structure

Assumptions of M&M theory
Effects of financial distress costs and agency costs on M&M theory
Alpha Corporation and Beta Corporation

Capital Structure

Reasons why Modigliani & Miller’s propositions were initially misunderstood
Modigliani and Miller’s propositions were initially misunderstood because of the irrelevance of the propositions that were proving to be irrelevant, still raising hackles in academic circles. The criticism revolving M&M’s failure to recognize the greater importance of adhering to taxes among other issues like incurring costs of in hiring lawyers in times of bankruptcy is expected. In addition, when bankers have the intention of increasing capital, M&M is not obliged to incur cost of investment bankers. It is however importance to state that some practice is expected to be adhered to as a benchmark when crafting economic models (Parrino & Kidwell, 2009).
Consequences of M&M propositions
Modigliani-Miller theory has an impact on the nature of capital markets in the global markets. The amount of impact that the M&M theorem has on the capital markets is measured by its impact on the leverage of any organization. It can be misinterpreted in practical scenarios which may provide the notion of endless financial leverage. The application should be based on understanding the impacts brought about by relaxing the assumptions. The M&M theorem is valued depending on how the assumptions are violated, rather than basing the value on the results obtained as well as how the theory is applied (Eckbo, 2008).
Optimal Capital Structure
Yes it does. Finance capital structure is defined as the manner in which corporate organization finance their assets by combining equity, debt or by combining the two aspects. The relevance of capital structure has been under question when it comes to perfectly competitive markets. This has been due to the fact that attaining a perfect market condition is largely an ideal. Some of the conditions it should meet include: firms and individuals can borrow at the same interest rate; no taxes; and Investment decisions are not affected by financing decisions (Crouhy, Galai & Mark, 2006).
Assumptions of M&M theory
Perfect Markets: The capital market is perfect and no single buyer or seller can influence security prices or interest rates. The Federal Reserve Open Market Committee cannot manipulate the price of treasury bonds and management cannot force prices upwards with stock buybacks. Perfect Knowledge: Information on securities is free and perfect. Investors all know with “perfect certainty” what the future will bring. Standard & Poor’s and Moody’s must go out of business. Companies never lie and provide complete and full information at all times. Corporate profits can be predicted with confidence for one hundred years or more. Free Transactions: There are no brokerage fees, dealer spreads, transfer taxes, or other transaction costs. Presumably, there would be no brokers, since there are no fees for intermediation. There also would be no stock exchanges or clearinghouses (Focardi, Frank & Fabozzi, 2004). Tax Neutrality: There is no tax difference between debt and equity, or between distributed and undistributed profits. Taxes are the same for all types of Investors. There is no tax on capital gains. It is evident that laws relating to corporate tax are give higher benefits to debt financing (usually the positive aspects outdo risks) as opposed to their favor towards equity financing.  This will mean more fund to finance the project at hand. Corporate and personal taxes do influence capital structures (Herbst, 2010).
Effects of financial distress costs and agency costs on M&M theory
Corporate tax determines capital structure. There is a difference in the tax treatment of dividends to common shareholders and interest paid to bondholders, at the corporate level. Because interest expense is deductible from corporate income while dividends are not, bond financing leads to a “tax subsidy” to the firm. The trade-off theory provides that firms are seeking debt levels which can balance the advantages in tax caused by an increase in debt as a result of costs of financial distress. It predicts moderate amount of debt as optimal (Correia, Flynn, Uliana, Wormald, 2007). But there is evidence that the most profitable firms in an industry tend to borrow the least, while their probability of entering in financial distress seems to be very low (Broyles, 2003).
High leverage tends to improve the efficiency of the managers and this will make investors to consider the issue of new debt in a favourable way and therefore agency costs can come into play in different ways i.e. Monitoring costs are incurred in the monitoring of expenditures made by the agents, Bonding costs are incurred in drawing up contracts and agreements by the principal with the agent and also taxes levied leaves the agents with lesser freedom to operate and has its own opportunity costs, in terms of a residual loss to the firm. This will in turn restrict the issue of equity/ debt, depending on the situation. Capital structure is therefore influenced by these costs (Barker & Powel, 2005).
Alpha Corporation and Beta Corporation
(a). The value of alpha corporation
Stock = 5,000 shares
Price = $ 20 per share
Earnings before interest = $35,000
Interest rate = 12%
Therefore, the value of alpha corporation is = 5,000 * 20 = $ 100,000
(b) The value of beta corporation
Market value of stock = $ 25,000
Debt cost = 12%
Therefore, the value of beta corporation is = 25,000* 20* 12% = $ 60,000
(c) Market value of beta corporation
The market value of beta corporation is 25,000*20 = $100,000
(d) cost of purchasing 20% of alpha stock = 100,000* 20% = $20,000
Cost of purchasing 20% of beta stock = 60,000*20% = $12,000
(e) Returns on alpha corporation stock = $35,000- $20,000 = $15,000
Returns on beta corporation stock = $35,000-$12,000 = $23,000
(f) cost of purchasing 20% of alpha’s equity = $15,000*20% = $3,000
Cost of purchasing 20% of beta’s equity = $23,000* 20% = $4,600
Therefore, the strategy of purchasing alpha’s equity and replicating in beta’s equity will help reduce the total costs by $4600-3000 = $1,600
(g) Alpha’s equity is less risky than beta’s equity because alpha’s equity are less costly and an investor can purchase alpha’s equity and replicate them in beta’s equity. By the mere fact that an investor can purchase stocks for Alpha Corporation and resell at a profit to Beta Corporation, it is evident that alpha equity has less risk. The risk attached to equity is determined by the value gained after selling the stock. Thus, it is evident that Beta Corporation’s equity has more risk than the alpha corporation’s equity. The greater the risk attached to equity the higher the returns gained (Focardi, Frank & Fabozzi, 2004). Investors who are risk averse will therefore prefer buying stocks from Alpha Corporation but investors who are risk takers will invest in Beta Corporation’s equity.

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