Analysis Of Modigliani-Miller
Modigliani – Miller
The most important building block of the contemporary understanding of capital structure is the Modigliani-Miller proposition about the irrelevance of capital structure. It argues that under the assumptions listed below, capital structure does not affect company value (Frank and Goyal, 2007).
Modigliani and Miller based their theorem on the following assumptions: “(i) neutral taxes, (ii) no capital market frictions (i.e., no transaction costs, asset trade restrictions or bankruptcy costs), (iii) symmetric access to credit markets (i.e., firms and investors can borrow or lend at the same, rate), and (iv) firm financial policy reveals no information” (Villamil, 2008).
In the real world, these assumptions do not hold, so …show more content…
However, if one relaxes another assumption, namely absence of bankruptcy costs, then bankruptcy becomes more likely as debt increases, which leads to a trade-off between the tax shields and expected bankruptcy costs. The notion that the optimal level of debt-to-equity ratio is determined by this trade-off is to be attributed to Kraus and Litzenberger (1970), while Myers argued that there is a concrete optimal level of leverage towards which adjustment happens (Myers, 1984; Frank and Goyal, …show more content…
If one considers an entrepreneur with a given amount of money who is trying to maximize his return by dividing the money between investment in the company and private consumption, and issues debt or equity if the optimal amount of investment exceeds his money, then it can be shown that the rational way to act for the entrepreneur is to underinvest when he issues equity. Also, he will have to give up a share of the returns to the holders of equity, so internal funds are the best way to finance investment, followed by debt and then equity. (Jensen and Meckling, 1976; Frank and Goyal, 2007)
Another agency cost is that management that holds equity in a leveraged company might make investments that are too risky because in case these investments turn out to be successful, then the management will profit from them, however in bad states of the world only the debt holders will bear the losses while managers will have no downside.
Market Timing
Baker and Wurgler (2002) have established that market timing plays an important role in practice in capital structure decisions. Market timing means that firms issue equity when it is expensive and buy it back when it is cheap. According to this theory, firms have no target debt-to-equity ratio, and the observed ratio is merely the result of past attempts to time the market (Baker and Wurgler,
The most important building block of the contemporary understanding of capital structure is the Modigliani-Miller proposition about the irrelevance of capital structure. It argues that under the assumptions listed below, capital structure does not affect company value (Frank and Goyal, 2007).
Modigliani and Miller based their theorem on the following assumptions: “(i) neutral taxes, (ii) no capital market frictions (i.e., no transaction costs, asset trade restrictions or bankruptcy costs), (iii) symmetric access to credit markets (i.e., firms and investors can borrow or lend at the same, rate), and (iv) firm financial policy reveals no information” (Villamil, 2008).
In the real world, these assumptions do not hold, so …show more content…
However, if one relaxes another assumption, namely absence of bankruptcy costs, then bankruptcy becomes more likely as debt increases, which leads to a trade-off between the tax shields and expected bankruptcy costs. The notion that the optimal level of debt-to-equity ratio is determined by this trade-off is to be attributed to Kraus and Litzenberger (1970), while Myers argued that there is a concrete optimal level of leverage towards which adjustment happens (Myers, 1984; Frank and Goyal, …show more content…
If one considers an entrepreneur with a given amount of money who is trying to maximize his return by dividing the money between investment in the company and private consumption, and issues debt or equity if the optimal amount of investment exceeds his money, then it can be shown that the rational way to act for the entrepreneur is to underinvest when he issues equity. Also, he will have to give up a share of the returns to the holders of equity, so internal funds are the best way to finance investment, followed by debt and then equity. (Jensen and Meckling, 1976; Frank and Goyal, 2007)
Another agency cost is that management that holds equity in a leveraged company might make investments that are too risky because in case these investments turn out to be successful, then the management will profit from them, however in bad states of the world only the debt holders will bear the losses while managers will have no downside.
Market Timing
Baker and Wurgler (2002) have established that market timing plays an important role in practice in capital structure decisions. Market timing means that firms issue equity when it is expensive and buy it back when it is cheap. According to this theory, firms have no target debt-to-equity ratio, and the observed ratio is merely the result of past attempts to time the market (Baker and Wurgler,