MM Propositions And Pecking Order Theory Analysis

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MM Propositions and Pecking Order Theory The modern capital structure theory started with MM Propositions. According to Brealey, Myers and Allen (2016), MM Propositions are based on the assumption that capital markets are perfect. Perfect capital markets mean that no taxes, no transaction costs, and complete information. Based on these assumptions, MM state their first proposition that firm value is irrelevant to the capital structure. With the consideration of the law of conservation of value, the market value of stocks must be equal to that of the assets of a firm (Brealey, et al., 2016). In other words, the cash flow paid to shareholders is the same to the cash flow generated from the firm’s assets, given the non-existence of taxes and …show more content…
(2015) show somewhat support for the pecking order theory but seem not to support MM Propositions. First of all, Graham et al. (2015) found that, given the use of different leverage measures, there is a broadly similar pattern of leverage. The leverage of companies increased from an initial low level to a high level in the post-1970. Moreover, the increase in companies’ leverage also indicates the tendency of companies to use debt. Especially, after the inclusion of NASDAQ firms, Graham et al. (2015) found that there is an overall upward pattern for the market-to-book ratios at the aggregated level. In other words, as the leverage of companies increases, the market- to- book ratios of them increase at the same period. When running the regression analysis, Graham et al. (2015) confirmed the significant association between leverage and market-to-book ratios. This suggests that the market value of companies is somewhat dependent on the capital structure of companies. However, under the MM Proposition 1, the leverage of firms does not lead to the growth in the market value of the company. It is clear that the findings of Graham et al. (2015) do not support the MM Proposition 1. The discrepancy between the MM Proposition 1 and the findings of Graham et al. (2015) is mainly due to the perfect capital market assumptions. The fractions in the real market make the arbitrage process useless. Thus, the market value of companies is likely to …show more content…
The value of a levered company is equal to the sum of an unlevered firm and the present value of tax shields minus the present value of financial distress costs (Ju, et al., 2005). Under this theory, an optimal capital structure is possible for companies, a point at which the marginal tax shield is equal to the marginal cost of financial distress. Accordingly, companies can adjust their capital structure to make it move towards the optimal one. In addition, different companies will have different optimal capital structure since they differ from each other in tax shields and costs of financial distress (López-Gracia and Sogorb-Mira, 2008). Furthermore, there are two versions of the trade-off theory: the static and the dynamic ones. Under the former one, companies moves towards their optimal capital structure and reach it when the value of companies is maximized. However, the static model cannot explain whether the speed towards optimal capital structure is enough or when the adverse relationship between profitability and leverage appears (Miglo, 2010). The dynamic trade-off theory usually account for transaction costs when companies consider to raise funds. Thus, companies do no constantly change their capital structure towards its optimal capital structure but do so when benefits surpass the costs (Miglo, 2010). Overall, the core idea of the trade-off theory is that the leverage level of companies is

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