Financial Management Theory Write Up Essay

2371 Words Mar 11th, 2012 10 Pages
M&M Proposition 1
The Modigliani-Miller theorem forms the basis of modern thinking on capital structure. The theorem states that under a certain market price process, in the absence of taxes, bankruptcy cists, agency costs and asymmetric information, an in an efficient market, the value of a firm is unaffected by how the firm is financed. Whether the firm’s capital is raised by issuing stock or selling debt does not affect the value of the firm. This theory is also referred to as the capital structure irrelevance principle, which we have already looked at in previous seminar discussions. There are two propositions which were discussed by Modigliani and Miller. The first proposition states that the value if a firm does not depend on
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This change is an example of financial restructuring, and these are financial transactions that change the capital structure of the firm without affecting its real assets. These transactions might involve issuing debt and using proceeds to repurchase stock or pay a dividend or selling stock and using proceeds to repay debt. No new money is actually being invested in the firm. M&M showed that if you, as an investor, decide that you do not like the effect the restructuring would have on your cash flows, management could go ahead with the restructuring and you could undo its effect on the cash flows you receive by making offsetting trades in your personal investment account. To undo the effects of the proposed financial restructuring, you would simply use the entire $200 special dividend to buy all of the perpetual bonds the firm issues. From that point forward, you would receive the first $10 that the firm earns each year as an interest payment on your bonds. In addition, you would receive any remaining cash flows because you would still own 100 percent of the stock. Just as before the restructuring, you would be receiving all of the cash flows generated by the firm. Only now, instead of receiving all of those cash flows as dividends, you would receive some cash in the form of interest payments. Management should not worry about any other considerations other than cash flows from operating activities. The focus should be on identifying whether particular

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