Capital Structure
Modigliani and Miller argued that capital structure is irrelevant, all other things being equal, but in the real world those other things are never equal. The factors that are ruled out of MM are neutral taxes, no capital market frictions, symmetric access to credit markets, and that firm finance policy reveals no information. Normally, arguments against the irrelevance of capital structure are based on these factors that MM assumed away (Villamil, n.d.). In the U.S., taxes on dividends are very different from the taxes paid on loan interest. There are transaction and bankruptcy costs; firms cannot borrow and lend at the same rate, and financial policy does reveal information. As such, MM does not hold in the real world, and this implies that capital structure does matter.
That capital structure does matter implies that for every firm there is an optimal capital structure. What that structure might be, however, is dependent on a wide range of factors, many firm-specific and some highly subjective. This results in firms having a wide range of capital structures, even within the same industry, and that might give the impression to the casual observer than capital structure does not matter. Yet, there are in all likelihood some very good reasons for the differences between capital structures of different firms.
The objectives of the firm and the personal taste of management -- especially its risk aversion -- are key elements that contribute to the choice of capital structure. In general, debt has a lower cost than equity, but it increases the risk to the company because it represents an obligation that must be paid from the firm's cash flows before it accrues to the shareholders. In contrast, equity is less risky but is more costly. All firms must make a tradeoff between the two, and firms that have many similarities will choose divergent courses. Consider the examples of Mattel and Clorox. Both firms deal in consumer products and they have relatively...
Capital Structure A project should not be evaluated in terms of capital structure. The financing of a project is a decision that is independent of the decision to undertake a project. This flows from the Modigliani and Miller Theorem where the choice of financing is irrelevant to the returns of the asset, all other factors being equal (Investopedia, 2012). The firm may have a preference for one type of financing or
Simerly and Li believe that an organization must find a match or fit between the demands of its competitive environment and its internal management systems in order to succeed and to survive." In general, the authors recommend firms in industries with low rates of environmental change high economic performance choose equity over debt in financing projects with uncertain outcomes. Conversely, firms in industries with high rates of environment change and
Financial Ratios a) The free cash flow model implies that the value of the firm is the present value of the expected future free cash flows. Under this model, capital structure can affect firm value. The free cash flow model is as follows (Cherewyk, 2015): FCF = EBIT (1-t) + depreciation -- CAPEX -- ? working capital -- ? other assets In this portion of the model, the free cash flow is not
Statement 3 Another important issue to consider in the contraction of debt is represented by the impact of this debt on the company stakeholders -- employees, business partners, the public, and most importantly, the share holders. The primary scope of the economic agent is that of creating value for its stakeholders, but excessive debt could jeopardize this desire, especially since debt is money that has to be repaid and it as
Modigliani and Miller famously argued that all other factors being equal, capital structure is irrelevant. In the real world, however, things are not equal. So the different assumptions that underlie the core of MM, as the theory is known, do not exist in real life. The implication of this for businesses, then, is that they need to examine the different factors that can affect their choice of capital structure and
For example, many of the large investment banks may choose to deal only with large deals will have minimum transaction sizes. Therefore, the first consideration may be the suitability of the bank given the size of the organization. There may also need to be consideration of the degree of attention and expertise that the investment banker direct with the company, even if the minimum is met, large organizations with
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