Compare the trade-off theory with the Modigliani-Miller theory. Which theory do you like better? Why

Expert Solution

Trade off theory advocates that an optimal mix of capital structure should be selected which is consisting of debt capital and equity capital and since the debt has interest tax shield associated with it, the benefits of interest rate tax shield should be traded off with the cost of financial distress which is associated with debt financing.

While Modigliani Miller approach focuses that debt financing should be more apt for the capital structure of the firm, as it provides with the interest benefits and it is not advocating for bankruptcy cost or cost of financial distress so it is a narrow approach.it also have a very cautious approach towards having a high rate of equity and it always advocate having a high rate of debt without giving any concern to solvency

I like Trade off theory better, because Trade off theory is a rational theory which focuses on providing and optimal mix of capital structure which have appropriate proportion of debt financing with equity financing that will maximize the overall rate of return on capital and minimise the cost of capital by trading off between the benefits of interest rate tax shield and cost of financial distress so that the firm can have an adequate amount of debt financing with equity financing

jeff jeffy answered 1 year ago

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The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) is an influential element of economic theory; it forms the basis for modern thinking on the capital structure of a firm. The MM theorem represents what could possibly be the most important theory in respect of the effects of the Capital structure of a firm and the value of that firm. Despite the enormous efforts by Modigliani and Miller and the entire time spent by numerous scholars critiquing this theory, the MM...

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Question

Compare the trade-off theory with the Modigliani-Miller theory. Which theory do you like better? Why

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Expert Solution

Related Solutions

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