This paper discusses five theories of capital structure which has been mostly argued in literature. Modigiliani miller approach and arbitrage financial. Capital structure and its 4 important theories ni, noi. But, in practice, bankruptcy costs exist and these costs are directly proportional to the debt level of the. Whether a firm is highly leveraged or has a lower debt component has no bearing on its market value.
Mm prove that the two effects exactly offset each other so that both the value of the firm and the firms overall cost of capital are invariant to. Introduction financial theory in the recent decades has gradually developed more complex theories of the capital structure optimization, which are necessary theoretical and methodological basis for the management of liabilities. The modigliani and miller approach to capital theory, devised in the 1950s, advocates the capital structure irrelevancy theory. In fact, the lifetime of the company is always, of course, finite and the inclusion of this significantly changes formulae obtained by mm, in particular for the weighted average cost of capital wacc. This is known as capital structure irrelevance, or modiglianimiller mm theory. The modiglianimiller theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, a companys value is unaffected by how it is financed, regardless of whether the companys capital consists of equities or debt, or a combination of these, or what the dividend policy is. Capital structure is still a puzzle among finance scholars. The first milestone on the issue was set by modigliani and miller1958 through which they presented in their seminal work two important propositions that shaped the economic theory behind capital structure and its effect on firm value. Theories of capital structure explained with examples. Valueirrelevance proposition by the modiglianimiller modiglianimiller mm proposition is the first theory about capital structure. Mm intuition 1 if firm a were to adopt firm bs capital structure, its total value would not be affected and vice versa. The modigliani and miller hypothesis is identical with the net operating income approach. Modigliani and miller mm are great academics in economics and finance who broadly studied the impact of capital structure on a companys value mm proposition 1 without taxes.
The theory provides insight into a firms capital structure decision in a capital market free of taxes, transaction costs, and other frictions. The mm theory was revolutionary and it changed market view forever. The modiglianimiller theorem of franco modigliani, merton miller is an influential element of economic theory. Modigliani and miller 1958 were the first ones to landmark the. The theory provides insight into a firms capital structure decision in a capital market free. Structure theories capital structure capital structure is the proportion of debt and preference and equity shares on a firms balance sheet optimum capital structure is that at which the weighted average cost of capital is minimum and thereby maximum value of the firm traditional approach the traditional approach argues that moderate degree of debt can lower the firms overall cost of. Although mm theory will not stand in a practical world which is obviously not perfect, it became a foundation for serious development of the currently popular capital structure theories such as tradeoff theory, static tradeoff theory, dynamic tradeoff theory. Capital structure, firm value, irrelevance theorem, arbitrage, payout policy 1. Simple financial theory shows that the total value of a company should not change if its capital structure does. The modiglianimiller mm theorems are a cornerstone of finance for two reasons. Theories of capital structure ppt capital structure cost.
Their corrected theory says that firm value is independent of capital structure except for the value added by the present value of interest tax shields. The capital structure substitution theory is based on the hypothesis that company management may manipulate capital structure such that earnings per share eps are maximized. Apr 08, 2009 chapter capital structure and leverage. Chapter iii concepts and theories of capital structure and profitability. Most research on capital structure has focused on public, non. This pecking order theory suits large firms wip and which has th high enough internal funds in the form of retained earnings and depreciation. We can rewrite the capital structure problem using the asset pricing framework. Through this equation modigliani and miller 1958 have. Capital structure theories c modigliani miller model mm mm approach supports the noi approach, i. The theorem was developed by economists franco modigliani and merton miller in 1958. Capital structure a reading prepared by pamela peterson drake outline 1. The patterns of corporate capital structures around the world are also discussed.
As a firm increases its leverage, the cost of equity will increase just enough to offset any gains to the leverage. Under prop 1, mm theorized that in a tax free environment, with perfect information and no costs for financial distress, capital structure is irrelevant and changing a firms capital structure will not impact the firms valuation. Capital structure irrelevance financial theory moneyterms. The first is substantive and it stems from their nature of irrelevance propositions.
Capital structure is also referred as financial structure of a firm. The theory of capital structure wiley online library. This is why it was named the modiglianimiller theorem, or the mm theory. The basic theorem states that in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is.
Since then, many economists have followed the path they mapped. The study of capital structure attempts to explain how listed firms utilise the mix of various forms of securities in order to finance investment. The criticism of the modigliani and miller hypothesis. Capital structure does not matter within a relevant rangethat is the primary theme of mm i. A reexamination of the mm capital structure irrelevance. Capital structure is also referred to as the degree of debts in the financing or capital of a business firm. Implications of mm theorem a leverage is irrelevant. According to mm proposition, firm value is irrelevant to capital structure or financing decision. Further research on the theory of capital structure uses modiglianimiller as a benchmark, and then relaxes some of the assumptions. Modiglianimiller and capital structure theory finance train. This is because ultimately, its value is that of the cash flows generated by its operating assets e. Capital structure theory modigliani and miller mm approach. Modigliani and miller were two professors who studied capital structure theory and.
The original propositions mmproposition i mm 1958 a. This suggests that the valuation of a firm is irrelevant to the capital structure of a company. Modigliani and miller were two professors who studied capital structure theory. Capital structure theory asks what is the optimal composition between debt and equity. Basic capital structure differences video khan academy. Top 4 theories of capital structure with calculations. This theory suggests the firm value is irrelevant to capital structure or financing decision.
The mm hypothesis reveals that if more debt is included in the capital structure of a firm, the same will not increase its value as the benefits of cheaper debt capital are exactly set off by the corresponding increase in the cost of equity, although debt capital is less expensive than the equity capital. The mm theory explains the effects a firms capital structure may have on the value of the company for investment purposes. The modern theory of capital structure began with the celebrated paper of modigliani and miller 1958. They mm pointed the direction that such theories must take by showing under what conditions capital structure is irrelevant. In this article, we consider the wacc of the company in the theory of mm and modify mm s theory for a finite lifetime company. The firms financial policy divides up this cashflow pie among different claimants e. The tradeoff theory emphasizes taxes, the pecking order theory emphasizes differences in information, and the free cash. A firms capital structure of a company does not affect its overall value. Tot is an extension of the mm theory suggested by myers 1984.
Determinants of capital structure empirical evidence from. In 1958 franco modigliani and merton miller published the cost of capital, corporation finance and the. Basic idea the basic intuition can be seen from pie charts below. The market value of any firm is independent of its 6. The free cash flow theory jensen 1989 states that when free. I will try to do proportional to the size so that right over there, that is the accounts payable the five thousand dollars. Modiglianimiller theory capital structure is irrelevant. The objective of the firm should be directed towards the maximization of the value of the firm the capital structure, or average, decision should be examined from the point of view of its impact on the value of the firm. Mar 25, 2014 capital structure theories c modigliani miller model mm mm approach supports the noi approach, i. M argue that, in the absence of taxes, a firms market value and the cost of capital remain invariant to the capital structure changes. The capital structure decision can affect the value of the firm either by changing the expected earnings or the cost of capital or both.
The capital structure puzzle myers 1984 the journal of. The criticism of the modigliani and miller hypothesis finance. Capital structure is a mix of debt and equity capital maintained by a firm. The capital structure of a firm is very important since it related to the ability of the firm to meet the needs of its stakeholders. Capital structure irrelevance under prop 1, mm theorized that in a tax free environment, with perfect information and no costs for financial distress, capital structure is irrelevant and changing a firms capital. Modiglianimiller mm approach it somehow supports noi approach it states that value of the firm must be constant irrespective of the degree of leverage even cost of capital as well as market price of share must be same operational justification for mm hypothesis is the arbitrage process arbitrage refers to buying an asset or security in market. Further, the mm model adds a behavioural justification in favour of the noi approach personal leverage assumptions o capital markets are perfect and. The basic theorem states that in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It is synonymously used as financial leverage or financing mix. The capital structure puzzle is unravelled and a clear picture is presented in terms of why capital structure matters.
Another way to generate balanced conclusions is to account for. Modiglianimiller mm advocated that the relationship between the cost of capital, capital structure and the valuation of the firm should be explained by noi net operating income approach by making an attack on the traditional approach. Trade off theory assumes that firms have one optimal debt ratio and firm trade off the. Value of firm ni, noi, mm approach financial management. A firms value will be determined by its project cash flows. Theories of capital structure ppt capital structure. Modigliani miller thesis of capital structure is akin to the net operating income approach.
Modigliani and miller originally stated that a companys value does not depend on the fraction of how it is financed, regardless of whether the companys capital holds as debt or equities, or a combination of these. Hence, theories of capital structure often assume some cost of bankruptcy that increases in debt, and derive optimal capital structure as the balance between the tax benefit and the bankruptcy cost. The definition states that the market value of a company is calculated. Capital structure is the proportion of all types of capital viz. The modigliani miller hypothesis is identical with the net operating income approach, modigliani and miller m. Introduction financial theory in the recent decades has gradually developed more complex theories of the capital structure optimization, which are necessary theoretical and. Based on this theory, there is an optimal capital structure that maximizes the firm value by balancing between debt tax shield and. Download free pdf study materials in financial management.
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