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Modigliani & Miller Summary

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Submitted By rotterdam87
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The cost of capital, corporation finance and the theory of investment
Modigliani & Miller – 1958

Introduction

In a world of certainty investment decision should be in line with either profit maximization or market value maximization. - According to profit maximization, a physical asset is worth acquiring if it increases the net profit of the owners of the firm. But net profit increases only if the expected rate of return on the asset exceeds the rate of interest - According to market value maximization an asset is worth acquiring if it increases the value of the owners equity i.e. if it adds more to the market value of the firm then the costs of its acquisition.

At a micro – economic level a world of certainty has little descriptive value. A risk factor should be taken into account when pricing capital.
Profit maximization and market value maximization seemed to have equivalent implications in a world of certainty, however in a world of uncertainty this equivalence vanishes. - Under uncertainty the profit outcome has become a random variable and as such its maximization no longer has operational meaning. - Market value maximization provides a workable theory of investment in a world of uncertainty. Under this approach any investment project and its financing plan must only pass the following test: Will the project, as financed, raise the market value of the firm’s shares? If so, is it worth undertaking; if not, its return is less ten the marginal (rwacc) cost of capital of the firm.

This paper will provide 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?

Assumptions

In developing their theory, MM assume the following:

- No taxes - No transaction costs (particularly no cost associated with issuing new debt

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