Miller and Modigliani Model
The Modigliani-Miller theorem forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price procedure, in the absence of taxes, bankruptcy costs, unsymmetrical information and agency costs and and in an efficient market, the value of a business firm is uninfluenced by how that business firm is financed. It does not matter if the business firm's capital is raised by issuing stock or selling debt. It does not matter what the business firm's dividend policy is. Consequently, the Modigliani-Miller theorem is also often known as the capital structure irrelevance principle.
Modigliani was presented the year 1985 Nobel Prize in Economics for this and other contributions. Miller was a professor at the University of Chicago when he was awarded the 1990 Nobel Prize in Economics, along with Harry Markowitz and William Sharpe, for their "work in the theory of financial economics," with Miller specifically cited for "fundamental contributions to the theory of corporate finance."
Checklist Description
This checklist describes the Modigliani-Miller theorem of capital structure, devised by Franco Modigliani and Merton Miller in 1958, which set out the ground works for modern thinking on corporate finance and capital structure.
The Modigliani-Miller theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, a company's value is uninfluenced by how it is financed, regardless of whether the company's capital comprises of equities or debt, or a combination of these, or what the dividend policy is. The theorem is also referred as the capital structure irrelevance principle.
A number of principles underlie the theorem, which adjudges under the assumption of both taxation and no taxation. The two most significant principles are that, first, if there are no taxes, raising leverage brings no benefits in terms of value creation, and second, that where there are taxes, such benefits, by way of an interest tax shield, fall when leverage is brought in or increased.
The theorem compares two firms: one unleveraged i.e. financed exclusively by equity and the other leveraged i.e. financed partly by equity and partly by debt and states that if they are indistinguishable in every other way the value of the two companies is the same.
As an illustration of why this must be true, suppose that an investor is believing purchasing one of either an unlevered company or a levered company. The investor could purchase the shares of the levered company, or purchase the shares of the unlevered company and take over an equivalent sum of money to that adopted by the levered company. In either case, the return on investment would be superpose. therefore, the price of the levered company must be the same as the price of the unlettered company minus the borrowed sum of money, which is the value of the levered company's debt.
There is an implicit assumption that the investor's cost of borrowing money is the same as that of the levered company, which is not necessarily confessedly in the presence of asymmetrical information or in the absence of effective markets. For a company that has risky debt, as the ratio of debt to equity raises the weighted average cost of capital remains constant, but there is a higher required return on equity since of the higher risk engaged for equity-holders in a company with debt.
Advantages
In practice, it's fair to say that none of the presumptions are met in the real world, but what the theorem teaches is that capital structure is significant since one or more of the presumption swill be violated. By applying the theorem's equations, economists can find the determinants of optimal capital structure and see how those components might affect optimal capital structure.
Disadvantages
Modigliani and Miller's theorem, which warrants almost inexhaustible financial leverage has been employed to boost financial and economic activities. However, its employ also resulted in raised complexity, lack of transparency, and higher risk and uncertainty in those activities. The global financial crisis of 2008, which saw a number of highly leveraged investment banks go wrong, has been in part assigned to excessive leverage ratios.
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