Therefore, they are prepared to lend the firm at almost same rate of interest. This is equal to the difference between the pure equity capitalization rate and ki times the debt-equity ratio. You want to expand, but it will require a new plant, hiring new employees, and opening new outlets. Modigliani and Miller Approach further states that the market value of a firm is affected by its future growth prospect apart from the risk involved in the investment. Generally, investors will buy the shares of the firm that's price is lower and sell the shares of the firm that's price is higher. This means that it is independent of the capital structure.
But in real world, this is far from truth. The Modigliani—Miller theorem of , is an influential element of economic theory; it forms the basis for modern thinking on. Illustration: Solution: Thus, from the above table, it becomes quite clear that cost of capital is lowest at 25% and the value of the firm is the highest at Rs 2,33,333 when debt-equity mix is 1,00,000 : 1,00,000 or 1 : 1. These two measures are also known as measures of capital gearing. This is illustrated in the following figure. No corporate income taxes exist.
We will discuss these theories one by one. Thus, the basic, proposition of this approach are enumerated below: a The cost of debt capital, K d, remains constant more or less up to a certain level and thereafter rises. They are: i The overall capitalization rate of the firm K w is constant for all degree of leverage; ii Net operating income is capitalized at an overall capitalisation rate in order to have the total market value of the firm. This process will be continued till both the firms have same market value. This suggests that the valuation of a firm is irrelevant to the capital structure of a company.
In other words, leveraging the company does not increase the market value of the company. Arbitrage process is the operational justification for the Modigliani-Miller hypothesis. So, the weighted average Cost of Capital K w and K d remain unchanged for all degrees of leverage. Capital structure is the mix of owner-supplied capital equity, reserves, surplus and borrowed capital bonds, loans that a firm uses to finance business operations. Prior work by Rajan and Zingales 1995 , La Porta et al. In the static tradeoff theory, optimal capital structure is reached when the tax advantage to borrowing is balanced, at the margin, by costs of financial distress. Instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the same amount of money B that firm L does.
The objective of the firm should be directed towards the maximization of the value of the firm the capital structure, or average, decision should be examined from the point of view of its impact on the value of the firm. The total financing remains constant. Thus, the basic proposition of this approach are: a The cost of debt capital, K d, remains constant more or less up to a certain level and thereafter rises. The indirect effects of mastery on leverage decisions sometimes reinforce and sometimes offset the direct effects. The same can be shown with the help of the following diagram:.
David Durand views: The existence of an optimum capital structure is not accepted by all. Due to increased financial risk, the cost of debt and cost of equity will presumably rise. However, M-M maintain that even if the cost of debt, Kd, is increasing, the weighted average cost of capital, Ko, will remain constant. The use of debt does not change the risk perception of the investors since the degree of leverage is increased to that extent. It is assumed that the firm will borrow the same amount of debt in perpetuity and will always be able to use the tax shield.
Proposition 1 In a tax environment, the value of a levered company is higher than the value of an unlevered company by an amount equal to the product of absolute amount of debt and tax rate. The Modigliani—Miller theorem states that the value of the two firms is the same. That is, if an investor purchases shares of a leveraged firm, it would cost him the same as buying the shares of an unleveraged firm. The operating earnings of the firm are not expected to grow. Embeddedness has no significant direct effect on foreign joint ventures' leverage decisions, but exerts its influence entirely through indirect effects. The first Firm U is unlevered: that is, it is financed by equity only.
This variation in Traditional Approach is depicted as under: Other followers e. The theory of optimal capital structure suggests that financing decisions require trade-offs among at least five elements: 1 tax benefits of debt financing, 2 costs of financial distress, 3 agency costs of debt, 4 agency costs of equity, and 5 signaling effects of security issuance see Jensen and Meckling, 1976; Myers, 1977; Senbet, 1980, 1981; Myers, 1984; Myers and Majluf, 1984; Haugen and Senbet, 1988; Harris and Raviv, 1991; Chaplinsky and Harris, 1996. It means to change the capital structure does not affect overall cost of capital and market value of firm. The business risk is assumed to be constant and independent of capital structure and financial risk. According to the pecking order theory changes in the level of debt are not motivated by the need to reach a given debt target, but instead are motivated by the need for external financing. Whether to finance through debt, equity, or a combination of both is a result of several factors.