Question

……………… proposes firm value will increase with financial leverage.

Select one:
a. Market Timing Theory
b. Pecking Order Theory
c. Trade-off Theory
d. Modigliani and Miller Theorem with taxes

Answer 1

d. Modigliani and Miller Theorem with taxes

REASON :

• The Modigliani-Miller theorem (M&M) states that the market value of a company is correctly calculated as the present value of its future earnings and its underlying assets, and is independent of its capital structure.At its most basic level, the theorem argues that, with certain assumptions in place, it is irrelevant whether a company finances its growth by borrowing, by issuing stock shares, or by reinvesting its profits.
• Market timing is a type of investment or trading strategy. It is the act of moving in and out of a financial market or switching between asset classes based on predictive methods. These predictive tools include following technical indicators or economic data, to gauge how the market is going to move.Many investors, academics, and financial professionals believe it is impossible to time the market. Other investors, notably active traders, believe strongly in it. Thus, whether market timing is possible is a matter of opinion. What can be said with certainty is it is very difficult to time the market consistently over the long run successfully.
• The Pecking Order Theory, also known as the Pecking Order Model, relates to a company’s capital structure. Made popular by Stewart Myers and Nicolas Majluf in 1984, the theory states that managers follow a hierarchy when considering sources of financing.The pecking order theory states that managers display the following preference of sources to fund investment opportunities: first, through the company’s retained earnings, followed by debt, and choosing equity financing as a last resort.
• The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger^[1] who considered a balance between the dead-weight costs of bankruptcy and the tax saving benefits of debt. Often agency costs are also included in the balance. This theory is often set up as a competitor theory to the pecking order theory of capital structure. A review of the literature is provided by Frank and Goyal.