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Principles of Finance - Essay Example

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Course 8 May 2012 In a world with corporate taxes Modigliani and Miller’s view is that a company should issue as much debt as possible. Why is this advice not followed by companies? Modigliani—Miller Theory First, it is imperative to comprehend the term capital structure…
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Principles of Finance

The composition and determination of the perfect capital structure has been an integral subject of research in corporate finance. The Nobel Prize winner theorem presented by Modigliani and Miller is the cornerstone of capital structure in today’s world. The crux of the theory is that under an effective market where there are no taxes, insolvency costs, agency costs, and asymmetric information, the value of a business is not established by sources of finance (Modigliani and Miller). They advocated that under perfect market condition, without any friction, the capital structure of the company does not influence its market value. Therefore, it is irrelevant whether an entity finances its capital by issuing shares or raising debt and the like ways. Similarly, an entity’s dividend policy is immaterial. Owing to these factors, this thermo is also termed as capital structure irrelevance principle. For instance, suppose there are two firms which are similar in every way except for their capital structures. One firm is financed merely through equity and the financial structure of the other one comprises of both, equity and debt (Miller). According to the ‘capital structure irrelevance principal’, both companies will carry the same worth. ...
He went on to elaborate, “The Modigliani—Miller proposition says that if there were no costs of separation (and, of course, no government dairy support program), the cream plus the skim milk would bring the same price as the whole milk”. The heart of this analogy was that expanding debt (cream) diminishes the worth of existent equity (skimmed milk). If secure cash flows are sold to debt holders, the firm will possess lesser worth equity; hence, the aggregate worth of the firm will remain unaltered. In other words, the gain from what appears cheaper debt is set off against the riskier and more expensive equity. Thus, the constitution of capital from debt and equity would be futile, given a certain quantity of aggregate capital. This is because the weighted average for any possible compositions of the two finance alternatives to the firm will remain unaffected. However, the condition of perfect condition is restricted to theorems so businesses in the real world are not subject to this environment. In addition, it is extremely rare for the capital structure of a company to be completely based on debt. Myriad arguments have emerged in opposition to Modigliani—Miller theorem; these accentuate taxation, agency costs, insolvency, equity dilution, credit rationing, conflicting interest of management etc. Modigliani and Miller recommended for firms to have a certain borrowing ability in case of an economic upheaval. Taxes The most evident drawback of the Modigliani—Miller theorem is the supposition the subtraction of interest and corporate taxation. Under most financial frameworks, tax cannot be computed until the deduction of interest owed to debt holders from the corporate profits. Therefore, the amount of corporate tax not charged serves as a subsidy based on ... Read More
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