Modigliani and Miller: A Challenge to Capital Budgeting Strategies Financing cor

Question

Modigliani and Miller: A Challenge to Capital Budgeting Strategies

Financing corporate purchases and overall capital budgeting usually requires the finance manager to assess tax rates, dividend payout policy, weighting of capital sources, and more. However, the Modigliani and Miller propositions state that, in most situations, it does not matter if the firm's capital is raised by issuing stock or selling debt. As a student you might assume studies of capital budgeting strategies will no longer be reviewed in coursework. Before coming to that conclusion please discuss the principles presented by Modigliani and Miller and explain your agreement or disagreement.

Explanation / Answer

Modigliani and Miller, in 1950s had studied capital-structure theory and developed the capital-structure irrelevance proposition.  They hypothesized that in perfect markets, it does not matter what capital structure a company uses to finance its operations. They theorized that the market value of a firm is determined by its earning power and the risk of its underlying assets, therefore its value is independent of the way it chooses to finance its investments or distribute dividends.

The basic M&M proposition is based on the following key assumptions:

I disagree with the Modigliani-Miller theorem because all of the scenarios presented are never true in real life because;

1.  Whenever a company issues stocks or bonds there will be transaction cost associated with them such as fees and commissions.

2. Every companiy' earnings are subject to taxation around the word, morever tin most of the countries tax rate corprate earnings are higher than tax rate applicable to individuals.

3. The idea that borrowing cost have to be equal for individuals and firms which does not happen in real life because corporates usually have a better credit rating than most individuals which allow them to borrow money at much better rates than most individual would ever be able to get.

References:

Ozyasar, H. (2015). Assumptions of the Modigliani-Miller Theorem.

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