modigliani and miller theory of capital structure ppt to pdf

Modigliani and miller theory of capital structure ppt to pdf

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Modigliani and Miller Approach

Theories of Capital Structure Ppt

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The initial increase in the cost of equity is more than offset by the lower cost of debt. But as debt increases, shareholders perceive higher risk and the cost of equity rises until a point is reached at which the advantage of lower cost of debt is more than offset by more expensive equity. It clearly shows that with increase in debt, overall cost of capital decreases but Value of the firm increases. EBIT Rs.

Modigliani and Miller Approach

The initial increase in the cost of equity is more than offset by the lower cost of debt. But as debt increases, shareholders perceive higher risk and the cost of equity rises until a point is reached at which the advantage of lower cost of debt is more than offset by more expensive equity. It clearly shows that with increase in debt, overall cost of capital decreases but Value of the firm increases. EBIT Rs. Open navigation menu. Close suggestions Search Search. User Settings. Skip carousel.

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Theories of Capital Structure Ppt

The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger [1] who considered a balance between the dead-weight costs of bankruptcy and the tax saving benefits of debt. Often agency costs are also included in the balance. This theory is often set up as a competitor theory to the pecking order theory of capital structure. An important purpose of the theory is to explain the fact that corporations usually are financed partly with debt and partly with equity. It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs e.

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We present an experiment designed to test the Modigliani-Miller theorem. Applying a general equilibrium approach and not allowing for arbitrage among firms with different capital structures, we find that, in accordance with the theorem, participants well recognize changes in the systematic risk of equity associated with increasing leverage and, accordingly, demand higher rate of return. Yet, this adjustment is not perfect: subjects underestimate the systematic risk of low-leveraged equity whereas they overestimate the systematic risk of high-leveraged equity, resulting in a U-shaped cost of capital. A control individual decision-making experiment, eliciting several points on individual demand and supply curves for shares, provides some support for the theorem.

The Modigliani and Miller approach to capital theory, devised in the s, advocates the capital structure irrelevancy theory. This suggests that the valuation of a firm is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or has a lower debt component has no bearing on its market value. Rather, the market value of a firm is solely dependent on the operating profits of the company.

Trade-off theory of capital structure

Capital structure and dividend policy are the most dominant decisions taken by the firm. How much the government takes in income taxes depends on the proportion of the stream paid out in a form that is deductible from the EBIT before the tax calculation is made. Investors value dividends and capital gains equally.

Assumptions of Modigliani and Miller Approach

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2 comments

  • Inconrighce 26.04.2021 at 16:36

    The basic concept of this approach is that the value of the firm is independent of its capital structure and determine solely by its investment.

    Reply
  • Kiera T. 28.04.2021 at 02:46

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