Question

Modigliani and miller demonstrated that "capital structure does not matter" in a perfect capital market. However, this statement is at odds due to market imperfections. Explain how market imperfections reshape firm's choice of capital structure.

Answer 1

Modigilani and Miller demonstrated through their theory that capital structure do not matter in an efficient market. As per thier theory, value of a two firm who have different capital structures have the same value. Thus a firm which has only equity (refereed as unlevered firm) have the value same of an identical fim which has both equity and debt (referred as an levered firm).

The basic premise of their theorem are as follows:

a. There are no taxes (in the thoery with tax, the assumptions the firms will be taxed at the same rate)

b. There are no transaction costs, floating costs and bankruptcy costs

c. Investors are rational

d. Individuals and Companies have same borrowing rates

All the above premise exists only in an efficient or a perfect market. But in reality, market is imperfect. In reality,

a. There are taxes and the tax rates might differ from firm to firm,

b. There are transaction costs of purchase and selling of securities

c. There are floatation costs such as underwriting commission etc

d. The borrowing rates differs for individuals and companies and also varies between the companies

e. Investors are irrational

f. There are no corporate dividend tax

These market imperfections influences the firm's choice of its capital structure as follows:

a. A firm which is liable to pay tax or pays higher taxes will prefer taking more debt compared to equity since the interest on debt is tax deductible.

b. Underwriting commission and other floatation costs are typically charged as a % of the new financing. These costs if significant may force the firm to prefer more debt than equity.

c. If the borrowing rate is higher for a company (because of its lower credit rating, etc), the firm may prefer equity in thier capital structure than the debt

d. The information available on a firm changes between investors and some possessing more information on the firm than others which will influence them in making decisions relating to investing in the company

These market imperfections makes the Modigilani and Miller theory irrelevant in actual business world.