Question

A- Discuss the traditional theory relating to capital structure and the approach by Modigliani and Miller

Answer 1

Traditional Theory of Capital Structure: According to this approach, the cost of capital is dependent on the capital structure and there is an optimal capital structure which minimizes the cost of capital. The real marginal cost of debt and equity is the same at the optimum capital structure. But the real marginal cost of debt is lower than the real marginal cost of equity before the optimal point.

Modigliani And Miller's Capital Structure Theories:Modigliani and Miller, two professors in the 1950s, studied capital-structure theory intensely. From their analysis, they developed the capital-structure irrelevance proposition. Essentially, they hypothesized that in perfect markets, it does not matter what capital structure a company uses to finance its operations. They theorized that the market value of a firm is determined by its earning power and by the risk of its underlying assets, and that its value is independent of the way it chooses to finance its investments or distribute dividends.

The basic M&M proposition is based on the following key assumptions:

•No taxes

•No transaction costs

•No bankruptcy costs

•Equivalence in borrowing costs for both companies and investors

•Symmetry of market information, meaning companies and investors have the same information

•No effect of debt on a company's earnings before interest and taxes