Modigliani And Miller's Irrelevance Theory Of Capital Structure

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INTRODUCTION Modigliani and Miller’s (1958) irrelevance theory of capital structure was a landmark research in the field of finance, leading to an increased interest in the corporate capital structure and its determinants amongst scholars over the following years. Essentially, Modigliani and Miller conclude that under certain assumptions, the market value of a firm and its capital structure are not related (Proposition 1). Additionally, they suggest that the expected yield of a stock share increases as the debt-to-equity rises, meaning that an investor would require a premium as a compensation to the risk stemming from the higher leverage (Proposition 2). It is important to note that Modigliani and Miller assume several restrictions for their …show more content…
Specifically, by removing the tax absence assumption, the trade-off theory implies that there are tax benefits as a result to interest payments by a firm, leading to higher market value. However, debt financing in a market with imperfections is suggested to involve some costs. Kraus and Litzenberger (1973) provide an example of this by proving that a potential increase of bankruptcy costs, as a result to higher gearing, would imply a decrease in the market value of a firm. Under these assumptions, a firm would set a target debt-to-equity ratio, which would balance the tax benefits and the costs arising from leverage in an optimal way (Myers 2003). An alternative approach to trade-off theory is known as pecking order theory (Myers 1984). Myers suggest that a company wishing to raise funds to prefer internal financing, debt as second option and new equity issue as the least preferred option. Pecking order theory takes into consideration not only the costs of bankruptcy but information asymmetry and transaction costs as well, in order to interpret the financing behavior of the …show more content…
As Grigore and Ştefan-Duicu (2013) state, according to agency theory the optimal capital structure of a firm is the outcome of a reconciliation of the conflicts of interest between the creditors, the managers and the shareholders of the firm. A lot of effort has been made so far to identify the determinants of the capital structure, but still there is not a generally accepted view. Furthermore, the stability of the capital structure is another important issue that concerns modern finance theory (DeAngelo and Roll 2015) The purposes of this paper are firstly to provide some insight on the determinants of the corporate capital structure and secondly to examine the extend at which it remains stable over the time. Literature review As mentioned in the previous chapter, the efforts of determining how the capital structure decision is influenced were concentrated by removing the strict assumptions of Modigliani and Miller irrelevance theorem (1958). In their subsequent work, Modigliani and Miller (1963) find that in the presence of taxes, leverage would create a tax shield, through the interest payments (trade-off

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