Question

Illustrate three main assumptions made by MM and discuss how the problems are tackled by alternative capital structure theories.

Answer 1

The three main assumptions made by MM are :

• There are no bankruptcy costs.
• There are no taxes
• there is symmetry of information, which means that the company and the investors have the same information.

According to the alternative capital structure theories:

In real life, there are taxes and bankruptcy costs and there is asymmetry of information as mangers have more information than the investors.

So, according to the trade off theory, a company should raise debt as long as the potential benefits of raising debt which is the interests tax shield is higher than the costs associated with the rising debt. Bankruptcy costs rises as too much debt is a threat to a company. As debt is cheaper, adding debt to the capital structure leads to lowering of the WACC but too much of debt is dangerous.  Therefore, the static trade-off theory identifies a mix of debt and equity where the decreasing WACC offsets the increasing financial risk to a company.

Due, to asymmetric information information between the mangers of a company and it's investors, a company should always use the retained earnings as a means of financing and should then select the debt and at lats should select equity as a means of financing for the company. In short word companies prefer internal financing compared to external financing.

SP, the pecking order theory provides a hierarchy of raising funds by the business.