The professors further theorized about the market value a any given firm being determined by not only the earning power of the given firm, but also by the risk associated to he underlying assets of the firm with the firms value being independent of the way it chooses to finance its investment or the distribution of the dividends. The capital structure theorists who are perceived to be orthodox are mainly divided into two different groups with the fundamentalists like Modigliani and Miller making arguments bout the world approaching perfection very much closely with the imperfections which might be offsetting to a great extent which consequently makes gearing not to matter in the real sense. Amongst the scholars classified as the revisionists include finance text authors who are famous for writing for a wide group of audience for whom theoretical ingenuity may in real terms not imply to the highest value but instead make attempts towards accommodating, though, within the confines of orthodoxy in what is described as the stark difference between Modigliani and Millers both theoretical analysis and empirical observations as regards to the importance that has been based on a firms capital structure not only by the firm itself, but by also the investors (Findlay and Williams, 1985). It is therefore evident that what they are in real sense arguing about is the importance of imperfections which further which further attributes to the reason making gearing very important hence they play quite a critical role in making us understand why different firms make the gearing decisions the way they do. This study will therefore critically analyze both the fundamentalist and revisionist positions. The Modigliani and Miller argument is mainly founded on the following basic assumptions; That there is absence of taxes, the absence of the costs of transactions, that there are no costs of bankruptcy, that there exists equivalence in the costs of borrowing not only for the companies, but also the investors, that there exists symmetry in the flow of market information as regards to both the companies and investors being in know how with the given information (Edwards, 1987). Lastly, the theory is based on the assumption that there exists no significant effect as regards the effect of debt on the earnings of the company before interest and taxes (Findlay and Williams, 1985). It must however be noted that the reality existent in the real world is that there are taxes, costs of bankruptcy, the costs of transactions, existence of various differences in not only the costs of borrowing, but also the asymmetries in the flow of information and the effects debts has on earnings. Thus, to gain a better understanding of the failures of Modigliani and Miller (MM) economic models of gearing, we will first briefly look at both prepositions. Modigliani and Miller’s Capital-structure Irrelevance proposition The capital structure irrelevance proposition propagated by Modigliani and Miller makes assumptions of the lack of both taxes and the costs of bankruptcy. According to the proposition, they argue that the weighted cost of capital of any given company remains constant in disregard to the numerous changes in the structure of any firm’s capital structure. A good example would the rate of borrowing of a given firm which would result in no tax benefits resulting from payments of interest hence resulting to no changes or benefits as regards the companies weighted average cost of
JPMorgan Income and PLC. Name: Course: Instructor: Date: In what ways do the main Modigliani and Miller (MM) economic models of gearing fail Introduction During 1950s, Modigliani and Miller gained popularity for their intense study on the capital-structure theory…
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