B1- Financial Management - Essay Example

If a firm becomes competent to establish this optimal capital structure, then it provides maximum returns to shareholders. In spite of this appeal by Modigliani and Miller, the optimal capital structure has not been found by researchers. This forms the basis of evaluation of the model depicted by Modigliani and Miller (Simerly & Li, 2002). The research paper is based on different arguments related to the approach of Modigliani and Miller with respect to its propositions. Modigliani and Miller have proposed two models in this context where one is with effect of corporate taxes and the other in absence of the corporate taxes.

The objective of this paper is to critically evaluate the models and present a critical understanding of the Modigliani and Miller propositions. The paper also deals with the identification of certain critical issues associated with the models and demonstrates the analyses of the issues. The purpose of the paper will be fulfilled by embracing different criticism of the two models and evidences related to their practicability. During the Belgium Tax Reform of 1982, the cost of equity was 13%. The cost of equity was tax deductible at the level of corporate during 1982-1983 for equities that were newly issued.

The following consequences of the situation were evaluated that depicted the propositions of MM approach when tax rate was considered: equities were issued in highest quantity during the period 1982-1983 which was more than that during the last 13 years. The Belgian stock market increased by 40% in December 1981. The consequences implies that since expected equity return increases with the amount of borrowing in the presence of corporate taxes, hence people strived towards buying more equity (Rao, 2010).

In MM Model of capital structure without taxes, markets are assumed to be perfect that means there are no taxes, no lawyers and no costs of bankruptcy. Now, on condition of market being perfect and efficient, Modigliani