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Principles of Finance - Essay Example
Finance & Accounting
Pages 8 (2008 words)
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…
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. ...
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