The M&M theory states it does not make any difference from an economists view wh

Question

The M&M theory states it does not make any difference from an economists view whether a firm raises financing as equity or debt. However floatation costs are more for equity than debt and interest on debt is tax deductible whereas dividends are not. How do you explain this difference between the market realities and the M&M theory? Further given the experience of Metalgesellschaft and Enron what business risks are related to excessive debt not accounted for by M&M? As explained in class all Bubbles start for a logical reason but when they collapse scams and scandals are often exposed. How does Enrons rise and collapse illustrate this proposition?

Explanation / Answer

M&M theory of capital structure is based upon the principle of ARBITRAGE and due to this principle, firms valuation does not depend upon the type of financing. Valuation of levered and unlevered firms will be in equilibrium on the basis of supply and demand forces. As Stocks of high valuation firms will be sold and stocks of lower valuation firm will be purchased and it will create equilibrium.

As far as floatation costs are concerned then in principle floatation cost of equity is higher than floatation cost of equity as discussed in the question. But, with increase in debt part of financing, cost of debt increases and it nullifies the earlier benefits of lower floatation cost. Also, it attracts financial risk which is very harmful to the company.

Business risk such as financial risk and management risk are associated with firm if they acquire excessive debt. It is surely not accounted by M&M approach but M&M approach thinks differently. It is focused upon ARBITRAGE trade off done by the investors in normal circumstance under certain assumptions. Those assumptions don

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