Question

Critically analyze the Modigliani and Miller’s Capital structure theorem. In doing so, recognize the impact of underlying assumptions. You should also review the competing theories of capital structure and assess whether they are realistic

Answer 1

As per Modigilani Approach Preposition I (With No Taxes), value of the enterprise does not depend on the capital structure of the firm. This preposition assumes no tax environment. The approach assumes that any reduction on cost of debt, in turn increases the cost of equity such that overall cost of capital is unchanged thereby the value of the firm is unchanged.

Cost of Levered Equity = Cost of Unlevered Equity + Debt / Equity (Cost of un-levered equity - Cost of Debt)

Under the Modigilani Approach Preposition I (With Taxes), the value of the firm will increase if the tax picture is considered. Hence value of firm will only increase by the tax portion of debt. The second preposition states that, the cost of equity has a direct relation with the level of debt. As level of debt increases, the default risk increases so does the cost of equity. However, it should be noted that the tax shield available due to taxes makes it less sensitive to changes in level of debt.

Cost of Levered Equity = Cost of Unlevered Equity + Debt (1- Tax)  / Equity (Cost of unlevered equity - Cost of Debt)

Trade off theory defines the most optimal capital structure under which company should operate. Static trade off theory was given by Modigilani Miller theorem which is mentioned above.

Pecking order theories does not give a optimal capital structure. However, it defines a general order in which funds should be raise ( Internal Profits, Short term debt, ,long term debt, preference shares, common stock). This theory gives a signal to the market. If company is able to raised funds internally then the company is strong. If it is raised through debt, then the management is confident in fulfiling the debt obligation. If through equity that means the company is not performing well and it is a negative signal and share price will start to fall. However, this thoery fails to recognise other factors which might impact the source of fund raising for the company.