Nobody downloaded yet

Discussion of the theories on Optimal Capital Structure - Essay Example

Comments (1) Cite this document
Summary
This paper discusses the theories on Optimal Capital Structure. For each theory it states the assumptions clearly. Also it explains the theories in detail and states the conclusions of each theory. In the paper appropriate diagrams to highlight the relationship between the cost of debt capital and the market capitalization are used…
Download full paperFile format: .doc, available for editing
GRAB THE BEST PAPER93.2% of users find it useful
Discussion of the theories on Optimal Capital Structure
Read TextPreview

Extract of sample "Discussion of the theories on Optimal Capital Structure"

Download file to see previous pages The study by Modigliani and Miller was based on the following assumptions:
1. There are no brokerage costs.
2. There are no taxes.
3. There are no bankruptcy costs.
4. Investors can borrow at the same rate as corporations.
5. All investors have the same information as management about the firm’s future investment opportunities.
6. EBIT is not affected by the use of debt.
This theory says that if these assumptions hold true, the value of the firm is not affected by the capital structure. This situation is expressed as follows:
VL = VU = SL + D.
Here VL is the value of a levered firm, VU is the value of an identical, unlevered firm, SL is the value of the levered firm’s stock and D is the value of its debt.
As we know that WACC is a combination of cost of debt and cost of equity. The cost of debt is lower than the cost of equity. As a company raises capital through debt, the weight of debt increases and hence, it drives up the cost of equity as equity gets riskier. According to the assumptions by Modigliani and Miller, the cost of equity increases by an amount to keep the WACC constant. In other words, under these assumptions it does not matter whether the firm uses debt or equity to raise capital. So, capital structure decisions are irrelevant in such conditions. Modigliani and Miller: The Effect of Corporate Taxes In 1963, Modigliani and Miller relaxed the assumption that there are no corporate taxes. The corporate tax laws favour debt financing over equity financing because the tax laws allow companies to deduct interest payments as expense and on the other hand dividends are not deductible. So this treatment encourages debt financing. Interest payments reduce the amount the firm pays to the government in the form of taxes and more of its cash is available for its investors. Hence, tax deductibility of the interest payments acts as a shield for the firm’s income before tax. Modigliani and Miller presented this concept as follows: VL = VU + Value of side effects = VU + PV of tax shield. They further simplified the concept as: VL = VU + TD. Here T is the corporate tax rate and D is the amount of debt. This relationship is expressed in the graph below. If the corporate tax rate is 40%, then this formula implies that every dollar of debt will increase the value of the firm by 40 cents. Hence, the optimal capital structure is 100% debt. Under this theory, the cost of equity increases as the amount of debt increases but it does not increase as fast as it does under the assumption that there are no taxes. As a result, under this theory the WACC falls as the amount of debt increases. This relationship is shown in the following graph. Miller: The Effect of corporate and personal taxes Later Miller brought in the aspect of personal taxes in this model. He said that income from the bonds is considered as interest which is taxed as personal income at a particular rate (Td). On the other hand, income from stocks comes in the form of dividends and capital gains. The tax on long-term capital gains is deferred until the stock is sold and the gain is realized. Of the stock is held until the owner dies no capital gains tax is paid. So he concluded that the returns on stock are taxed at a lower effective tax rate (Ts) than returns on debt. Looking gat this, Miller argued ...Download file to see next pagesRead More
Cite this document
  • APA
  • MLA
  • CHICAGO
(“Discussion of the theories on Optimal Capital Structure Essay”, n.d.)
Retrieved de https://studentshare.org/finance-accounting/1390904-corporate-finance
(Discussion of the Theories on Optimal Capital Structure Essay)
https://studentshare.org/finance-accounting/1390904-corporate-finance.
“Discussion of the Theories on Optimal Capital Structure Essay”, n.d. https://studentshare.org/finance-accounting/1390904-corporate-finance.
  • Cited: 0 times
Comments (1)
Click to create a comment or rate a document
cu
cummerataeldora added comment 10 months ago
Student rated this paper as
I had an issue with a essay types of works. All until I came across this website and this particular essay. Even though "Discussion of the theories on Optimal Capital Structure" is far from my interests, the structure is so great that I use it all the time as an example for my own works.

CHECK THESE SAMPLES OF Discussion of the theories on Optimal Capital Structure

Analysis capital structure of saudi companies

...overview 6 1.2 Background of the research topic 6 1.3 Research objectives and questions 7 1.4 Significance of the research 7 1.5 Chapter summary 9 Chapter 2: Literature review 10 2.1 Chapter overview 10 2.2 Theories 10 2.3 Optimal capital structure literature 14 2.4 Factors influencing capital structure 15 2.5 Arab countries 17 2.6 Chapter summary 29 Chapter 3: Methodology 30 3.1 Chapter overview 30 3.2 Research study and methodology 30 3.3 Subjects of research 31 3.4 Type and source of data 32 3.5 Method of analysis 33 3.6 Variables used in the study 33 3.7 Chapter summary 34 Chapter 4: Results 35 4.1 Chapter overview 35 4.2 Summary of...
4 Pages(1000 words)Essay

Capital structure analysis

...?Capital Structure Analysis Table of Contents Problem 28 3 Prob. a) 4 Prob. b) 5 Prob. c) 5 Prob. d) 5 References 7 Bibliography 7 Problem 28 Info Systems Technology (IST) is a manufacturer of microprocessor chips. The company has 100 million shares outstanding and no debt. Now, IST is supposed to raise capital worth $500 million in order to build a fresh production facility. In the occurrence of a financial distress, the company would experience a great loss of both consumers as well as engineering talents. If IST takes a debt of $500 million, the managers of the company are afraid that the present value of the cost of financial distress would be more than the tax benefits by an amount...
3 Pages(750 words)Math Problem

Optimal Capital structure problems

...? Capital Structure Memo Irving Sharp, Chairman and CEO All Seasons Hotel. Dennis Mark, CFO All Seasons Hotel. Date: 3rd December 2013 Subject: Proposed Capital Structure It is important for “All Season” to come up with a specific debt to equity ratio that will optimize the cost of capital of a company. This is the position at which the company’s value will be maximized. The fact that Cost of Capital has been always been shallow, the maximum debt/equity ratio can be defeated without raising the cost of capital. This will create a range in the lower portion of the graph where the cost of capital is similar throughout the range. There is certainty of getting off these ranges. The cost of capital will rise when it is off the range... to the...
3 Pages(750 words)Coursework

Risks and Optimal Capital Structure

...Order#:164054 Risk and optimal capital structure Small businesses are a huge activity for the U.S population. This is due to the fact that the US is well known for its edge in entrepreneurship. Some start-ups are as a result of need to diversifying investments or a way of self employment. Either way investors commit their financial resources in the hope of reaping some financial gains in future. Investments are veiled with uncertainty of getting any returns or even retaining the initial investment capital. This is called risk. When choosing an investment, one must carefully evaluate changes in the risk factor. Investors have to consider the amount of risk they can...
3 Pages(750 words)Essay

Capital Structure

...high cash) rather than investing in equity markets. The author wishes to argue that how these companies comply with the balancing theory of Modigliani and Miller. (1963. pp441-442) Holding debt money for longer will lead to serious implications on NPV leading to liquidity problems in the long run. How does private firms mitigate such risks This is the third set of discussion points proposed by the author. Conclusion: In this short essay, the author presented arguments on optimal capital structure after analyzing the empirical generalizations pertaining to the same. In the end the author presented few discussion points. Reference...
6 Pages(1500 words)Essay

The Capital Structure

...clearly showing that financing methods are not driven by any considerations to optimal capital structure. (LEWIS, 1964; LYNN et al, 1994) The pecking order theory on the other hand explains the reason of companies not behaving as per the static trade off theory. This theory states that companies have a preferred hierarchy when it comes to financing decisions: 1- Internally Generated Funds 2- Debt 3- New issue of equity This pecking order theory was developed to show the inconsistency between the trade off theory and the practical solution preferred by companies. Usually, companies tend to look at the...
8 Pages(2000 words)Essay

Determinants of capital structure

...-67. Eisen, P. J., 2007. Accounting. 5th edn. New York: Barrons Educational Series. Fridson, M. and Alvarez, F., 2011. Financial statement analysis: A practitioners guide. New Jersey: John Wiley & Sons. Harris, M. and Raviv, A., 1991. The theory of capital structure. Journal of Finance, 46(1), pp. 297-355. Michaelas, N., Chittenden, F. and Poutziouris, P., 1999. Financial policy and capital structure choice in U.K. SMEs: Empirical evidence from company panel data. Small Business Economics, 12, pp. 113-130. Peterson, P. P. and Faboozi, F. J., 2012. Analysis of financial statements. 3rd edn. New Jersey: John Wiley & Sons. Phillips, F., Libby, R. and...
20 Pages(5000 words)Essay

Capital structure

...in these cases become price takers, with little ability to raise concerns over the developments in the market. Before the merging process, there has to be a careful analysis of the short and long-term outcomes, this is because, mergers that fail to pick up as expected results in heavy losses to investors besides loosing on the lucrative investment opportunities. References Ehrhardt, M. C., & Brigham, E. F. (2014). Corporate finance: A focused approach. Mason Ohio: South-Western. Fabozzi, F. J. (2011). The theory and practice of investment management. Hoboken, N.J: Wiley. Horngren, C. T., Harrison, W. T., & Oliver, M. S. (2012). Financial & managerial accounting: The managerial chapters.Boston: Prentice Hall. Martin, G....
10 Pages(2500 words)Research Paper

Capital Structure

...Capital Structure In the present competitive scenario, companies are required to conduct business operations with incorporating the aspect of better investment management. In this similar context, I identified that the capital requirement of a firm is dependent on two sources that mainly include equity and debt. Respectively, I conjure that varied capital sources are typically based on different costs and thus, needed appropriate analysis for designing an optimal capital structure for raising required finance appropriately (Grundy, n.d.). In businesses, sources of capital comprise equity and debt, which...
2 Pages(500 words)Essay

Optimal Capital Structure

...sometime. Therefore, for analysts as well as prospective buyers, the capital structure of an organization bears immense importance. The essay is structured to introduce the term capital structure to the audience, through the eyes of prominent Franco Modigliani and Merton Miller, discussing the two propositions that were made. The discussion moves onto developing further methods to understand the capital structure and to analyze kind of structure works the best for the organization. CAPITAL STRUCTURE: The term...
12 Pages(3000 words)Coursework
sponsored ads
We use cookies to create the best experience for you. Keep on browsing if you are OK with that, or find out how to manage cookies.

Let us find you another Essay on topic Discussion of the theories on Optimal Capital Structure for FREE!

Contact Us