Modigliani & Miller's Capital Structure Theory

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Modigliani & Miller two professor in the late fifties they create the capital structure theory which state that in the perfect market the capital structure of a firm is irrelevance to the firm value or to the WACC it is independent from divided policy or way of investing.
M&M theory determine that the market value of the firm depend on the earning power and the risk away from the capital structure which is the way the firm finances its operations or growth by Debt or Equity (issuing stocks or RE) or by combining both.
M&M theory operate in perfect economy, free of taxes, bankruptcy, transaction and have the symmetries information, which in real world not possible, but it will give us highlight about how we want _____________________
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and it has two …show more content…

Business risk (cost of assets) depend on the way the firm operate their activity the greater the business risk the greater RA the grater the RE
2. Financial risk which depend on how the firm finance their activity, when the debt increase the risk increase and the shareholders voice increase asking for higher RE = their risk.
Case two: taxes, no bankruptcy
In this case M&M included the taxes and explain the impact of the tax in firm value and WACC.
M&M proposition 1 (Firm value)
They state that the value of the firm increase when we increase the debt in the capital structure this increase = PV of interest tax shield which equal the amount you save from deducting interest in another word having debt decrease your tax.
In conclusion the levered firm value is equal to the unlevered firm value plus the PV of interest tax shield (VL= VU + T*D) based on this case we can say that the optimal capital structure when the firm funded only by debt.
M&M proposition 2

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