Question

1. Describe the main results of Modigliani and Miller Propositions (I and II) for:
   1. 1958 model – no taxes, no bankruptcy costs
   2. 1963 model – with taxes, no bankruptcy costs
   3. Tradeoff model – with taxes and bankruptcy costs

In total there are 6 results

Answer 1

Describe the main results of Modigliani and Miller Propositions (I and II) for

a) No taxes, no bankruptcy costs

Answer:-

The MM I proposition with no taxes and no bankruptcy costs says capital structure is irrelevant. This means that the proposition of debt and equity in capital structure is irrelevant.

The MM II proposition without taxes and no bankruptcy costs with consideration of cost of equity and leverage says the with increase of cheaper debt financing the increases the cost of equity which results in a zero net change of WACC, while the capital structure is irrelevant.

b) With taxes, no bankruptcy costs

Answer:-

In this case of MM I with taxes and no bankruptcy costs the tax deductibility of the interest payments creates tax shield adds to the value of the firm and the optimal capital structure is achieved with 100% debt.

The MM II proposition with taxes and no bankruptcy cost says the WACC is minimized with 100% debt in the capital structure

c) Trade-off model, with taxes and bankruptcy

Answer:-

In Trade-off model with taxes and bankruptcy costs trade-off theory of capital structure is to see that a company chooses how much debt and how much equity is used to finance to balance the costs and benefits.

The trade-off theory forecasts the marginal tax benefit of debt should be equal to the marginal expected bankruptcy cost.