...Modigliani and Miller approach to capital theory, devised in 1950s advocates 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 lower debt component, it has no bearing on its market value. Rather, the market value of a firm is dependent on the operating profits of the company. Capital structure of a company is the way a company finances its assets. A company can finance its operations by either debt or equity or different combinations of these two sources. Capital structure of a company can have majority of debt component or majority of equity, only one of the 2 components or an equal mix of both debt and equity. Each approach has its own set of advantages and disadvantages. There are various capital structure theories, trying to establish a relationship between the financial leverage of a company (the proportion of debt in the company's capital structure) with its market value. One such approach is the Modigliani and Miller Approach. This approach was devised by Modigliani and Miller during 1950s. The fundamentals of Modigliani and Miller Approach resemble to that of Net Operating Income Approach. Modigliani and Miller advocates 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 lower debt component in the financing mix, it has...
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...------------------------------------------------- Modigliani–Miller theorem From Wikipedia, the free encyclopedia The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), 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.[1] It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani–Miller theorem is also often called the capital structure irrelevance principle. Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions. Miller was a professor at the University of Chicago when he was awarded the 1990 Nobel Prize in Economics, along with Harry Markowitz and William Sharpe, for their "work in the theory of financial economics," with Miller specifically cited for "fundamental contributions to the theory of corporate finance." Contents [hide] * 1 Historical background * 1.1 Without taxes * 1.2 With taxes * 2 Notes * 3 References * 4 External links | ------------------------------------------------- Historical background Miller and Modigliani derived the theorem and wrote their groundbreaking article when they were both professors...
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...Franco Modigliani Paper assignment Franko Modigliani was born in 1918 in Rome. He spent his childhood in Italy and finished Rome University with the degree of Doctor of Laws, in the same year he left Italy because of his Jewish origins and Antifascistic views. Firstly, he moved to France with his wives family and then moved to USA. He was an instructor of economics and statistics At Columbia University and Bard College from 1942 to 1944. In 1944 he also got degree of Doctor of social sciences at New School for Social Research. He defended his thesis for Doctor degree on the topic of “Liquidity Preference and the Theory of Interest and Money”, and was teaching there for a three years. This work was the first publication of Modigliani in English and, in his opinion, it was one of his main achievements. In 1946, he became a naturalized citizen of United states of America. After 1948 he joined University of Illinois, then Carnegie University (1950-1960), and North-Eastern University (1960-1962) afterwards. Since 1962, as a professor of Massachusetts Institute of Technology, he continued he continued his researches in the field of Macroeconomics that he started before, especially Theory of Cash cylces. During these years, he begins study international financial and billing systems, consequences and methods of fighting with inflation, stabilization policy in open economies. Most widely known works of Modigliani was his works in various areas of finance. 1) Personal Finance ...
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...Fernández PricewaterhouseCoopers Professor of Corporate Finance IESE Business School, University of Navarra Camino del Cerro del Aguila 3. 28023 Madrid, Spain. E-mail: fernandezpa@iese.edu Abstract This paper addresses the valuation of firms by cash flow discounting. The first part shows that the four most commonly used discounted cash flow valuation methods (free cash flow discounted at the WACC; cash flow for equityholders discounted at the required return on the equity flows; capital cash flow discounted at the WACC before taxes; and Adjusted Present Value) always give the same value. The disagreements in the various theories on the valuation of the firm arise from the calculation of the discounted value of tax shields (VTS). The paper shows and analyses 7 different theories on the calculation of the VTS: Modigliani and Miller (1963), Myers (1974), Miller (1977), Miles and Ezzell (1980), Harris and Pringle (1985), Ruback (1995), Damodaran (1994), and Practitioners method. The paper also shows the changes that take place in the valuation formulas when the debt's market value does not match its book value. JEL Classification: G12, G31, M21 October 16, 2008 (First version: July 2, 1999) Another version of this paper may be found in chapters 17, 18, 19 and 21 of the author's book Valuation Methods and Shareholder Value Creation, 2002 Academic Press, San Diego, CA. Pablo Fernández. IESE Business School ∗ -2- This paper addresses the valuation of firms by cash flow...
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...The Development of Modern Finance "A Short History of Value" David Roubaud & Jean-Charles Bagneris 10/2011 The Main Steps of the Theory Building • Portfolio Selection (Markowitz, 1952) • CAPM (Sharpe, 1963) • Financing and Dividend Decisions Neutrality (Modigliani et Miller, 1958, 1961,1963) • Efficient Markets (Fama, 1965, 1970) • Options Pricing Theory (Black & Scholes, 1973, Myers, 1977) • Agency Theory (Jensen, Meckling, 1976) • Efficient Markets II (Fama, 1991) • Behavioural Finance (Kahneman & Tversky, 1979, Shiller, 1981, 2000) Portfolio Selection • Investors are rationals and risk averse • Diversification lowers specific risk • Any portfolio is a combination of the market portfolio and the riskless asset The CAPM Capital Asset Pricing Model • Systematic risk of an asset is measured by its beta coefficient • The model calibrates the risk-return relationship • Simple, elegant and linear model => big success • Low explaining power (strong assumptions) • Alternative models are difficult to use 1 The Development of Modern Finance 2 Financial Markets Efficiency "At any given point in time, assets prices on financial markets account for all available information." • Strong assumptions on: – markets organization – investors behaviour • One consequence of EMH is Random Walk Hypothesis • Assumptions are not always true: 3 forms of efficiency (strong, semi-strong, weak) The irrelevance of financing and dividends decisions In a world without taxes and with perfect financial markets...
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...In 1958, Franco Modigliani and Merton Miller revolutionized the whole area of corporate finance with their article “The cost of capital, corporate finance and the theory of investment”. Before Modigliani’s and Miller’s article, literature on the topic mainly focused on descriptions of methods and institutions. Theoretical analysis was very rare (Pagano 2008). Under the assumption of perfect capital markets, the Modigliani-Miller Proposition I states that “the average cost of capital to any firm is completely independent of its capital structure and is equal the capitalization rate of a pure equity stream of its class” (Modigliani, Miller 1958). In Proposition II, Modigliani and Miller argue that “that the expected yield of a share of stock is equal to the appropriate capitalization rate for a pure equity stream in the class, plus a premium related to financial risk equal to the debt-equity ratio times the spread between” the capitalization rate and the return on debt. The most important implication of this theory is that if there is an optimal capital structure for a firm, this has to be the result of market imperfections. The Modigliani-Miller Theorem has thus become a starting point for further research and a benchmark for testing new theories on capital structure, that incorporate the impact of different market imperfections. The following text will focus on two of these theories, the static trade-off theory and the pecking order theory. The first part will contain a description...
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...This paper provides a theory on the effect of financial structure of the firm on market valuations. In other words, does capital structure influence value of the firm? I believe the introduction of the paper gives an important explanation of how Modigliani has reached his theorem, because his main goal was to correct the drawbacks of other theories. To understand the importance of such a theory, I considered adding these other theories as an introduction of this summary. The cost of capital to the owners of a firm is simply the rate of interest in bonds; this has derived the proposition that the firm, acting rationally, will tend to push investment to the point where the marginal yield on physical assets is equal to the market rate of interest. This proposition follows from either of two criteria of rational decision-making: (1) the maximization of profits, and (2) the maximization of market value. Under either formulation, the cost of capital is equal to the rate of interest on bonds. These have equivalent implications under certainty (Certainty Equivalent Approach) but not under uncertainty. The attempt of allowing uncertainty takes the form of superimposing on the results of the certainty analysis the notion of a risk discount to be subtracted from the expected yield. No satisfactory explanation has yet been provided as to what determines the size of the risk discount and how it varies in response to changes in other variables. The profit maximization criterion, under the...
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...Dividend policy theories (By Munene Laiboni) 1. Introduction: Dividend policy theories are propositions put in place to explain the rationale and major arguments relating to payment of dividends by firms. Firms are often torn in between paying dividends or reinvesting their profits on the business. Even those firms which pay dividends do not appear to have a stationary formula of determining the dividend payout ratio. Dividends are periodic payments to holders of equity which together with capital gains are the returns for investing in a firm’s stock. The prospect of earning periodic dividends and sustained capital appreciation are therefore the main drivers of investors’ decisions to invest in equity. In this paper, we explore various theories which have been postulated to explain dividend payment behavior of firms. Major Schools of thought: At the heart of the dividend policy theories discussion are two opposing schools of thought: One side holds that whether firms pay dividends or not is irrelevant in determining the stock price and hence the market value of the firm and ultimately its weighted cost of capital. In retrospect, the opposing side holds that firms which pay periodic dividends eventually tend to have higher stock prices, market values and cheaper WACCs. The existence of these two opposing sides has spawned vast amounts of empirical and theoretical research. Scholars on both sides of the divide appear relentless on showcasing the case for their arguments. Several...
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...effects. First, firms of the same risk class could possibly have higher cost of capital with higher leverage. Second, capital structure may affect the valuation of the firm, with more leveraged firms, being riskier, being valued lower than less leveraged firms. If we consider that the manager of a firm has the shareholders' wealth maximisation as his objective, then capital structure is an important decision, for it could lead to an optimal financing mix which maximises the market price per share of the firm. Capital structure has been a major issue in financial economics ever since Modigliani and Miller (henceforth referred to as MM) showed in 1958 that given frictionless markets, homogeneous expectations, etc., the capital structure decision of the firm is irrelevant. This conclusion depends entirely on the assumptions made. By relaxing the assumptions and analysing their effects, theory seeks to determine whether an optimal capital structure exists or not, and if so what could possibly be its determinants. If capital structure is not irrelevant, then there is also another thing to consider: the interaction between financing and investment. But in order to try to distinguish the effects of various determinants on capital structure, it is assumed in this paper that the investment decision is held constant. II. TRADITIONAL VIEW OF CAPITAL STRUCTURE In 1959, Durand listed the alternative approaches to valuation (Van Horne, 1990:321). Let kd represent the yield on debt...
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...Modigliani and Miller's Capital-Structure Irrelevance Proposition Modigliani and Miller, two professors in the 1950s, studied capital-structure theory intensely. From their analysis, they developed the capital-structure irrelevance proposition. Essentially, they hypothesized that in perfect markets, it does not matter what capital structure a company uses to finance its operations. The MM study is based on the following key assumptions: * No taxes * No transaction costs * No bankruptcy costs * Equivalence in borrowing costs for both companies and investors * Symmetry of market information, meaning companies and investors have the same information * No effect of debt on a company's earnings before interest and taxes In this simplified view, it can be seen that without taxes and bankruptcy costs, the WACC should remain constant with changes in the company's capital structure. For example, no matter how the firm borrows, there will be no tax benefit from interest payments and thus no changes/benefits to the WACC. Additionally, since there are no changes/benefits from increases in debt, the capital structure does not influence a company's stock price, and the capital structure is therefore irrelevant to a company's stock price. However, as we have stated, taxes and bankruptcy costs do significantly affect a company's stock price. In additional papers, Modigliani and Miller included both the effect of taxes and bankruptcy costs. The MM Capital-Structure...
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...Capital Structure Stewart C. Myers The Journal of Economic Perspectives, Vol. 15, No. 2. (Spring, 2001), pp. 81-102. Stable URL: http://links.jstor.org/sici?sici=0895-3309%28200121%2915%3A2%3C81%3ACS%3E2.0.CO%3B2-D The Journal of Economic Perspectives is currently published by American Economic Association. Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/about/terms.html. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/journals/aea.html. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. The JSTOR Archive is a trusted digital repository providing for long-term preservation and access to leading academic journals and scholarly literature from around the world. The Archive is supported by libraries, scholarly societies, publishers, and foundations. It is an initiative of JSTOR, a not-for-profit organization with a mission to help the scholarly community take advantage of advances in technology. For more information regarding JSTOR, please...
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...Empirical Corporate Finance * Table of Content Table of Content i 1 The Porsche Takeover 1 2 FPL Case 3 2.1 Expected Reaction of Stock Price 3 2.1.1 The Modigliani/Miller Theorem 3 2.1.2 The Tax Theory of Dividends 4 2.1.3 The Signaling Theory of Dividends 5 2.1.4 Agency Costs 5 2.1.5 Theory of Dividends Based on Tax Clienteles 6 2.2 Chart in the Light of Previous Theories 7 3 Elton and Gruber (1970): “Marginal Stock Holders tax Rates and the Clientele effect”, Review of Economics and Statistics 52, p. 68-74 8 3.1 Investors’ Marginal Tax Rate 8 3.2 Ex-Dividend Price Decline 8 3.3 Equal Tax Rates 9 4 Reference List 9 Allen, F., Bernardo, A.E., & Welch, I. (2000). A theory of dividends based on tax 9 clienteles. The Journal of Finance, 55(6), S. 2499-2536 9 * The Porsche Takeover To answer the question it has to be distinguished between common stocks (ordinary shares) and preferred stocks: Common stock (ordinary stock) can be defined as a “security representing ownership of a corporation” (Brealey, Myers, & Allen, 2011, p. 913). In this context ownership means “the right to the cash flows and the right to take all financing, and investment decisions, and full cash flow and full control rights”. Preferred stock on the other hand can be defined as a “stock that takes priority over common stock in regard to dividends. Dividends may not be paid on common stocks unless dividend is paid on all preferred stocks. The dividend...
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...reference is made to how debt is used as a signalling tool along with a discussion on debt maturity structure. The pecking order theory is examined. Finally this paper reveals empirical evidence of capital structure. Arnold Musadziruma 210525268 Clint Kruger 209541568 Kemsley Grantham 209538112 i “Seminar 4- Capital structure and information asymmetry (2013)” Abstract This study is going to discuss capital structure choices of companies in an environment of information asymmetry. Firstly we discuss information asymmetry and how firms attempt to avoid a pooling equilibrium by signalling the quality of the firm. Quality can be signalled through the use of debt. The use of long term debt is a sign that a firm can make the payment obligations of the long term debt which is shown to signal good quality. The pecking order theory makes use of a hierarchy of financing sources and indicates internally generated funds should be used first. Following this, short term debt should be used before long term debt because of the risk and costs involved. Due to the costs involved in issuing equity in an environment of information asymmetry, firms should make use of equity as a last resort. The maturity structure of debt should also match the maturities of those firms’ assets to reduce costs. Empirical evidence suggests there is no common result for which theory is followed in practice; however it is shown that small firms who are high growth firms tend to follow a pecking order and larger...
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...According to Modigliani-Miller theorem, in a perfect capital market (no transaction or bankruptcy costs; perfect information); firms and individuals can borrow at the same interest rate; no taxes; and investment decisions aren't affected by financing decisions. Modigliani and Miller made two findings under these conditions. Their first 'proposition' was that the value of a company is independent of its capital structure. Their second 'proposition' stated that the cost of equity for a leveraged firm is equal to the cost of equity for an unleveraged firm, plus an added premium for financial risk. That is, as leverage increases, while the burden of individual risks is shifted between different investor classes, total risk is conserved and hence no extra value created. Under a classical tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure then would be to have virtually no equity at all. However, there is no such perfect market in real world. Under this situation, capital structure is necessary when scrutinize a company’s performance from finance perspective. And our project will examine the capital structure of Coca Cola Company from the aspects of Trade-off theory (bankruptcy cost and debt issue), Pecking order theory (financing priority), and Agency cost (debt-to –equity ratio and cash flow), because all of these theories are related...
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...The Capital Structure of Nicci’s Pizza Palace September 13, 2011 The Capital Structure of Nicci’s Pizza Palace A company is funded by debt, equity, or retained earnings. The mixture of debt and equity is the company’s capital structure. There are four factors that influence capital structure; business risk, tax position, financial flexibility, managers, growth rate, and market conditions. Management’s decisions concerning capital structure should be geared toward maximizing the intrinsic value of the company. This value is the present value of its expected future free cash flows (FCF) discounted at its weighted average cost of capital (WACC). Business risk is the basic risk of the company's operations (EBIT), excluding debt. It raises the question how well can a company’s operating income be predicted? There are several unknown variables that can assist in answering this question. The product for example, has a cost associated with its’ creation. Then there is the uncertainty of how much to charge for it, demand, operating leverage, etc. The general rule is: the greater the business risk, the lower the optimal debt ratio. Operating leverage is the use of fixed costs rather than variable costs. It is a measure of whether a company is getting value for its costs. It “can be a very powerful thing. With a cost structure geared toward a high proportion of fixed costs and few variables in the mix, strong sales almost automatically translate into higher profit growth. Companies...
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