List the three assumptions that lie behind the Modigliani-Miller theory in a world without taxes. Are...

List the three assumptions that lie behind the Modigliani-Miller theory in a world without taxes. Are these assumptions reasonable in the real world? Explain.

Expert Solution

Assumption 1 - Markets are perfect (i.e. No transaction cost , No bankruptcy cost , No restriction on short selling , Securities are fully divisible).

This Assumption is Not reasonable in the real world because in real life Markets are not perfect i.e. there are restriction on short selling , there are transaction costs & the securities are not divisble too.

Assumption 2 - No Agency cost, which means that there is no conflict of interest between shareholders & Management.

This Assumption is Not reasonable in the real world because in real life there is conflict of interest between shareholders & Management. For example, Management may buy other companies to expand power. Venturing onto fraud, they may even manipulate financial figures to optimize bonuses and stock-price-related options.

Assumption 3 - Investment Decissions are unaffected by financing decissions. (i.e. Level of EBIT does not depend on how funds are raised)

This Assumption is also Not reasonable in the real world as Investment Decissions are Affected by financing decissions. i.e. investment, financing & dividend decisions are inter related because the underlying objective of these 3 decisions is the same, i.e. maximisation of shareholder's wealth. Since investment, financing & dividend decisions are all interrelated, one has to consider the joint impact of these decisions on the market price of the company's share & these decisions should also be solved jointly.

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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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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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List the three assumptions that lie behind the Modigliani-Miller theory in a world without taxes. Are...

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