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Marine Finance(Capital Funding Structure) - Essay Example

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A UK-listed high-growth company that wants to expand operations or take advantage of a promising investment opportunity is faced with the challenge of how to obtaining additional financing. The chief financial officer of the company also has to make a choice whether the…
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Marine Finance(Capital Funding Structure)
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Marine Finance(Capital Funding Structure)

Download file to see previous pages... In 1958, Franco Modigliani and Merton Miller, two prominent financial economists, constructed a theory of capital structure (usually referred to as the MM) that is widely considered as the most influential financial theory up to this time. Basically, the MM theory assumes perfect capital market conditions where all relevant information is readily available, where there are no transaction costs, and where borrowing and lending rates are the same for all investors. The theory likewise assumes that there are no income taxes, that operating income is constant over time -- i.e., there is no growth -- and that all earnings are paid out as dividends.
In 1963, Modigliani and Miller modified their original work by including corporate taxes. With such taxes, leverage would increase the firms value because interest on debt is a tax-deductible expense and more income accrues to the investors. Consequently, the value of the firm increases. The cost of debt is the after-tax yield (1-tax). This lower cost of debt, combined with the existing cost of equity, will result in a lower weighted average cost of capital the greater the leverage. The benefits of debt financing derive from solely from the tax deductibility of interest payments. This observation would lead one to conclude logically that the company should use more leverage to the extent that all financing will be done through debt. In reality, however, companies do no such thing. While historically the debt/asset ratios have risen overall, companies maintain capital structures that are stable with a some combination of debt and equity at some in-between point. (See Brealey & Myers; Brigham & Gapenski; Keat & ).
Much later, Merton Miller extended the theory by including personal taxes. Personal taxes in the modified model would reduce -- but not eliminate -- the benefits of debt financing. Because the introduction of personal taxes lowers the income to investors, they reduce the value ...Download file to see next pagesRead More
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