Capital Structure
This is because of the irrelevance of the propositions that are proving to be anything but irrelevant, still raising hackles in academic circles. Not surprisingly, critics question M&M’s otherworldly assumptions–that companies don’t have to pay corporate taxes, don’t have to pay investment bankers to raise capital, don’t have to pay lawyers when in bankruptcy, and don’t withhold information from capital markets. (Such simplifying assumptions are, of course, standard practice in economic model making.)
it is difficult to determine the exact extent to which the Modigliani–Miller theorem has impacted the capital markets, it can only be urged to the extent that it has promoted and expanded the use of leverage the argument can be made that it has been used to promote and expand the use of leverage. It can be misinterpreted in practice which my give a notion of limitless financial leverage while on the other hand it is not properly accounting for the increased risk especially bankruptcy risk that use leverage ratios. Thus its application should be focused on understanding the implications that the relaxation of those assumptions bring. This is because of the fact that the value of the theorem primarily lies in understanding the violation of the assumptions in practice, rather than the result itself, its application should be focused on understanding
Yes it does. Finance capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance. Some of the conditions it should meet include
firms and individuals can borrow at the same interest rate;
no taxes;
Investment decisions aren’t affected by financing decisions.
Assumptions on M&M theory
Perfect Markets: The capital market is perfect. 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.)
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. Corporate tax laws favor debt financing over equity financing. With corporate taxes, the benefits of financial leverage exceed the risks. This will mean more fund to finance the project at hand. Corporate and personal taxes do influence capital structures
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. According to the trade-off theory, firms seek debt levels that balance the tax advantage of an increase of debt with the prospective costs of possible financial distress. It so predicts moderate amount of debt as optimal. It so predicts moderate amount of debt as optimal. 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. This fact contradicts the theory because, if the distress risk is low, an increase of debt has a favourable (and almost riskless) tax effect. On agency costs, financial policy acts as a signal for the markets in that high leverage tends to improve the efficiency of the mangers. 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
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