Modigliani And Miller's Theory Of Capital Structure
The first assumption from Modigliani and Miller (1958) is that firms operate within a perfect capital market. The perfect capital market is defined by Fabozzi, Neave and Zhou (2012, p 87). Firstly, they state that a perfect capital market is a market in which all participants have the same probability distributions over future uncertain returns. This means financing decisions should not impact on the business risk of the firm. Secondly, in a perfect …show more content…
They propose that firms should only undertake projects that maximize profits or market value of shares. To do this, projects should have a higher expected return than the interest rate, otherwise a firm would simply deposit money in the bank. However, a firm also needs to consider the riskiness of each type of financing.
This leads onto the next set of assumptions, whereby Modigliani and Miller (1958) explicitly assume that all firms are categorized by classes of ‘equivalent return.’ They state that this implies that the ratio of actual return to expected return has the same probability distribution for all shares in that class. Thus allowing firms to be classified as homogeneous. They also assume that share are traded in perfect markets.
Modigliani and Miller (1958) build on this mathematically to show the value of a firm is based on its profitability, rather than its capital structure. To examine this theory in depth, consider the mathematics proposed by Modigliani and Miller (1958) whereby they show
V_j≡(S_j+D_j )=X ̅_(j/ρ_k )
X ̅_j is the expected profit before interest
D_j is the market value of …show more content…
Thus, due to limited liability shareholders are protected from the firms’ outstanding debts. This allows them to take on risk.
They also go on to consider some later work by Modigliani and Miller (1963), who show debt can be used to create a tax shield on interest payments. Jensen and Meckling (1976) then hypothesize why firms are not simply financed using debt. They notice that in light of the benefits of debt, firms should simply use a small amount of equity and a large amount of debt. According to Modigliani and Millers (1958) irrelevance theorem, this should have no effect on firm value.
Jensen and Meckling (1976) reconsider Modigliani and Millers (1958) assumption that probability distributions of cash flow are independent of capital structure. Suggesting that this cannot hold in the presence of tax subsidies as well as bankruptcy costs. Rather, they suggest that due to the Agency costs, the future cash flows probability distribution is not independent of capital structure and ownership. The reasons for this are describes systematically under the title ‘The Agency Costs of