Modigliani & Miller Approach to Capital Theory - Essay Example

Corporate Finance Table of Contents Introduction 3 Assumptions of Modigliani & Miller Approach 3Empirical Implication of Modigliani & Miller Approach 4 Two propositions without taxes 4 Propositions with taxes: The trade-off theory of leverage 4 Application of Theory in the Determination of WACC 5 Practical Usefulness and Applicability of Theory in Real Life Business 5 Conclusion 7 Reference List 8 Introduction The approach of Modigliani & Miller to capital theory was developed in 1950s, supports capital structure immateriality theory. This proposes that the assessment of a company is not relevant to its capital structure. Whether a company has lower component of debt or is extremely leveraged, it does not have any bearing on its actual market value. Instead of this, the market worth of the company depends on its operating profits. Company’s capital structure is the means by which a company funds its assets. It can finance or fund its operations either through equity or debt or dissimilar combinations of these sources (Miller and Modigliani, 1961). Company’s capital structure can comprise of majority of equity or debt component, an equal combination of both or only one of them. Each approach includes its own advantages as well as disadvantages. The hypothesis on capital structure from the Modigliani & Miller is considered as one of the significant developments or progress in the area of corporate finance (Miller, 1988). The report will highlight the main foundations and implications of Modigliani & Miller approach towards the capital structure. It will also focus on how this theory is related to the purpose of weighted average cost of capital (WACC) for a company. Further, the report will take into consideration the practical applicability and usefulness of the theory in real life business. Assumptions of Modigliani & Miller Approach There are five assumptions of this approach which involves: no taxes; transaction price/cost for selling and buying securities and also the cost of bankruptcy is nil; there is evenness of information which means that the investor will have the right to use the similar information that the corporate would and it also means that the investors are required to behave rationally; the borrowing cost is same for companies as well as investors; and financing of debt does not involve any effect on the firm’s earnings before interest and tax (EBIT). The approach of Modigliani & Miller signifies that the value of leveraged company (i.e. the company having the mixture of equity and debt) is similar to the unleveraged company’s value (i.e. the company which is completely financed by means of equity) if the future prospects and the operating profits are same. It further explains that if the investor buys leveraged firm’s share, it would rate him on the same scale as purchasing the unleveraged firm’s share (Casamatta, 2003). Empirical Implication of Modigliani & Miller Approach The theorem of Modigliani & Miller makes the basis of contemporary corporate finance. It defines that this approach presents situations under which the financial decision of the company does not have an effect on its value. The empirical implications of Modigliani & Miller are based on the above assumptions (Edwards, 1987). Two propositions without taxes Proposition 1: With the assumption of ‘neutral or no taxes’, it has been proposed that the capital structure/composition of the company does not have an influence on the company’s valuation. It means that leveraging the firm does not augment the market worth of the firm. It also proposes that equity shareholder as well as the debt shareholder have equal priority i.e. income is split evenly amongst them (Miller, 1977). Proposition 2: It states that the financial leverage of the company is in the direct/straight proportion to the price of equity. With the augmentation in the debt element, the equity shareholders recognize a higher or great risk for the firm. In return, they anticipate a higher return, thus increasing the equity cost. Here the main distinction is that the proposition 2 presumes that share holders of debt have advantage or control as far as the claim of income is concerned. In this way, the debt cost reduces (Miller, 1977). Propositions with taxes: The trade-off theory of leverage The approach of Modigliani & Miller presumes neutral or no taxes. Though in reality, this does not happen. Most of the countries take tax from the companies. This hypothesis identifies that tax advantages accrued through interest payments. The interest which is given on the borrowed funds or resources is normally tax deductible. Though, the case is not same with the dividends paid or compensated on equity. The theory of trade-off states that a firm can take advantage of its prerequisite with debts provided that the bankruptcy’s cost exceeds the cost of the tax benefits. This theory also states that the agency conflict/divergence play a significant part in financing the decisions (Levy and Sarnat, 1978). The approach defines that any adjustment in the debt to equity ratio impacts the weighted average cost of capital. They are negatively related to each other, which mean that lower the debt, higher is the weighted average cost of capital and vice versa. The approach of Modigliani & Miller is regarded as the contemporary approaches of the capital structure supposition (Harris and Raviv, 1991). Application of Theory in the Determination of WACC The Modigliani & Miller irrelevance proposition of capital-structure assumes neutral/no taxes as well as no costs of bankruptcy. In this view, the WACC must remain stable with alteration in the capital structure of the company. For example, it does not matter that how the company borrows, there would be no benefit of tax from the interest payment as well as no benefits or changes to the WACC. While there are no benefits or changes from increment in debt so, the capital structure of the company does not have an impact on its stock price as well as the capital structure of the firm is also irrelevant to its share price (Modigliani and Miller, 1963). The second proposition of Modigliani & Miller deals with WACC. As the percentage of debt increases in the capital structure of the company, its return on shareholders’ equity rise in a linear proportion. The presence of higher levels of debt makes investing more risky in a firm, and due to this the shareholders demand elevated risk premium usually on the stock of the company. As the capital structure of the company is irrelevant therefore the changes or alteration in debt to equity ratio does not have an effect on the weighted average cost of capital. The second proposition of Modigliani & Miller with the corporate taxes allows the savings of corporate tax from the deduction of interest tax and hence concludes that the changes or alteration in debt to equity ratio do have an effect on WACC. Thus, a large percentage of debt actually lowers the weighted average cost of capital of the company (Myers, 1984). Practical Usefulness and Applicability of Theory in Real Life Business The decision on the capital structure is an important fundamental issue which are faced by the supervisors and executives in today’s company. The term capital structure is referred to the mixture of debt, common stock, and preferred stock of finance which is used by the company in order to fund the financing of long term. Debt and equity capital are considered as the two main sources of funds of long term for a company. The capital structure theory is closely linked with the company’s cost of capital (Kaplan and Per, 2003). Evidence from the developed markets shows that the companies in the developed countries does not take into account the deductibility of tax on the payment of interest as a significant factor, when selecting the appropriate debt amount (Townsend, 1979). It has been noticed that the potential bankruptcy or the financial distress or the near-bankruptcy costs, and the credit rating are more influencing factors. This indicates that the companies in the developed markets, such as the UK and US endeavour to balance the possible costs as well as the debt’s benefits. In support of the Modigliani & Miller’s trade-off hypothesis, it has been analysed that the instability of cash flows and earnings increases the threat or risk of the financial distress, thus affecting the financing decisions of the companies. 26% of the companies do not have any target debt to equity ratio. 10% of the companies in the developed markets have strict target for the debt to equity ratio and 64% of them encompass a flexible target for the debt to equity ratio (Townsend, 1979). Furthermore, maintaining a debt to equity ratio is not considered as an important issue by the companies when they have to make decision whether to raise capital stock. Only 9% of the companies in the developed markets categorises the problem of free cash flow as very important or important (Puxty and Dodds, 1991). This emerges as totally different in relation to the theory about the Modigliani & Miller’s trade-off approach with the agency costs. In reality, the agency costs do not play a significant part in financing the decisions. Furthermore, the notion that the capital stock is enhanced when the internal funds are inadequate gets less approval in real world. Equity emerges to be the only resort for offering funds or finances when all the financing sources/means have been shattered. Very few companies have the opinion that debt provides investors with the better thought of the company’s vision than issuing the common stock. The companies in the developed countries do not agree that the changes in the common stock’s price and the valuation of current share are the vital issues when they are making the financing decisions. The firms also do not agree on the matter that they issue debt at the time of low interest rate (Schmidt, 2003). The cross country investigation in the developed markets shows positive relationships among ‘debt’ and ‘size and tangibility’. All countries reveal that the investment opportunities comprise of a negative influence on the leverage. Referring to the tax benefits which support debt, the theory of trade-off is not accepted in real life situation as the companies avoid the lenders’ constraints. The U.S. indicated a positive relationship among tangibility and debt as well as size and debt. The firms in the United States of America employ greater share of debt of short term (Myers and Majluf, 1984). Banks want to provide debt of long term to those companies which have the development prospects. The companies which are having significant amount of the tangible assets utilises more amount of debt of long term which shows that they are matching long term liabilities with the fixed assets. This further shows that firms maintain a little financial risk, as in the emerging countries they face more economic risk. The variable ‘size’ is directly related to the debt ratios, signifying that firms in the developed markets expand based on the liabilities. The companies which use less amount of debt are more profitable. The firms in the emerging countries also revealed same results as in the developed countries. The economic environment of the company influences the financing decision as well as capital mix. Most of the studies indicate that firms do not take the benefit of tax shield and therefore this variable is found to be irrelevant (Zender, 1991). Conclusion The decision on the capital structure is considered as the most essential issues in the corporate finance. To achieve most favourable capital structures, it is observed that the company must be a combination of debt and equity. Debt is cheaper in comparison to equity, partly due to the reason that lenders accept less risk as well as partly due to the reason that the tax benefits are related with debt. The assumptions of Modigliani & Miller approach has been taken into consideration. The approach of Modigliani & Miller signifies that the value of leveraged company is similar to the unleveraged company’s if the future prospects and the operating profits are same. The empirical investigation of the Modigliani & Miller approach takes into account the propositions without taxes and also with taxes. The approach states that any changes in the debt to equity ratio impacts WACC. The theory is also applied in the determination of weighted average cost of capital. The companies in the developed markets indicate proportions of higher debt when they hold significant amount of the tangible assets. This shows that the theory of trade-off is relevant, signifying that the fixed assets are utilised for the purpose of accessing loans of the long term. Tax shield is considered as inappropriate because the organizations do not take the benefit of it. It has been also analysed that size variable has an affirmative influence on the debt; therefore the companies can actually access more amount of debt when they encompass an excellent status on financial market. Reference List Casamatta, C., 2003. Financing and Advising: Optimal Financial Contracts with Venture Capitalists. Journal of Finance, 58, pp.2059-2086. Edwards, J., 1987. Recent Developments in the Theory of Corporate Finance. Oxford Review of Economic Policy. 3(4), pp.1-12. Harris, M. and Raviv, A., 1991. The theory of optimal capital structure. Journal of Finance, 48, pp.297-315. Kaplan, S. and Per, S., 2003. Financial Contracting Theory Meets the Real World: Evidence from Venture Capital Contracts. Review of Economic Studies, 70, pp.281-315. Levy, H. and Sarnat, M., 1978. Capital Investment and Financial Decisions. London: Prentice-Hall. Miller, M. H. and Modigliani, F., 1961. Dividend Policy, Growth and the Valuation of Shares. Journal of Business, 34, pp.411-433. Miller, M.H., 1977. Debt and Taxes. Journal of Finance, 32, pp.261-275. Miller, M. H., 1988. The Modigliani-Miller Proposition after Thirty Years. Journal of Economic Perspectives, 2(1), pp.99-120. Modigliani, F. and Miller, M. H., 1963. Corporate Income Taxes and the Cost of Capital: A Correction. American Economic Review, 53, pp.433-443. Myers, S.C., 1984. The Capital Structure Puzzle. Journal of Finance, 39(3), pp.575-592. Myers, S.C. and Majluf, N., 1984. Corporate Financing and Investment When Firms have Information that Investors do not have. Journal of Financial Economics, 11(1), pp.187-221. Puxty, A. G. and Dodds, J.C., 1991. Financial Management: Method and Meaning. London: Chapman and Hall. Schmidt, K. M., 2003. Convertible Securities and Venture Capital Finance, 58, pp.1139-1166. Townsend, R. M., 1979. Optimal Contracts and Competitive Markets with Costly State Verification. Journal of Economic Theory, 20(1), pp.265–293. Zender, J., 1991. Optimal Financial Instruments. 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