Question

8. List the assumptions under which Modigliani and Miller proved that a firm’s value is unaffected by its capital structure, then explain trade-off theory, signaling theory, and the effect of taxes and bankruptcy costs on capital structure?

Answer 1

MODIGLIANI AD MILLER THEORY:

* This theory derived in the 1950s advocate capital structure irrelevance theory.

* MM theory states that the market value of a firm affected by its future growth prospect apart from the risk involved in the investment.

* This theory further States that valuation of firm is relevant to the capital structure of the company whether the firm is highly.

Assumptions:

* Capital markets are perfect.

* No transaction cost.

* Non existence of corporate tax.

* Dividend payout ratio is 100%.

* Investors are free to buy and sell the securities.

TRADE-OFF THEORY:

* Trade-off theory is that a firm identify an optimal target capital structure that they believes balance the benefit of the tax shield against the cost of financial distress.

* Important purpose of this theory is to explain the fact that corporations usually are financed partly with debt and partly with equity.

SIGNALING THEORY:

* This theory is generally concerned with the reduction of information asymmetry between two market actor.

* In this the signaler (firm) will engage in the purposefull behavior to communication information that reduces information asymmetry in a manner beneficial to the firm.

assumptions:  

* The notion of signal quality.

EFFECT OF TAXES ON CAPITAL STRUCTURE:

* If firm uses debt then rate of return on equity will be high and there will be tax saving but not in every case. * Tax consider in deciding capital structure:

• Effect of corporate tax return

• Cost of capital and its tax treatment

• Flotation cost and its tax treatment

EFFECT OF BANKRUPTCY ON CAPITAL STRUCTURE:

* This cost depending on the structure and size of company. It includes legal fees, loss from selling distressed assets etc.

* A firm never wants to lever its capital structure beyond this optimal level so that its WACC is high, its interest payment are high and its risk of bankruptcy is high.