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Discussion of the theories on Optimal Capital Structure - Essay Example
This paper discusses the theories on Optimal Capital Structure. For each theory it states the assumptions clearly. Also it explains the theories in detail and states the conclusions of each theory. In the paper appropriate diagrams to highlight the relationship between the cost of debt capital and the market capitalization are used…
The study by Modigliani and Miller was based on the following assumptions:
1. There are no brokerage costs.
2. There are no taxes.
3. There are no bankruptcy costs.
4. Investors can borrow at the same rate as corporations.
5. All investors have the same information as management about the firm’s future investment opportunities.
6. EBIT is not affected by the use of debt.
This theory says that if these assumptions hold true, the value of the firm is not affected by the capital structure. This situation is expressed as follows:
VL = VU = SL + D.
Here VL is the value of a levered firm, VU is the value of an identical, unlevered firm, SL is the value of the levered firm’s stock and D is the value of its debt.
As we know that WACC is a combination of cost of debt and cost of equity. The cost of debt is lower than the cost of equity. As a company raises capital through debt, the weight of debt increases and hence, it drives up the cost of equity as equity gets riskier. According to the assumptions by Modigliani and Miller, the cost of equity increases by an amount to keep the WACC constant. In other words, under these assumptions it does not matter whether the firm uses debt or equity to raise capital. So, capital structure decisions are irrelevant in such conditions. ...