The Trade Off Theory: Franco Modigliani And Merton Miller

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The two economists Franco Modigliani and Merton Miller were the first ones who examined the capital structure’s effect on the firm value in 1958.They assumed that under the perfect market conditions, the capital structure does not affect the corporate value. Modigliani and Miller (1963) took taxation under consideration and proposed that the firms should use as much debt as possible. Companies have an advantage in using debt rather than using equity,because using the debt make them enjoy the debt tax shield. This tax shield allows firms to pay a much lower tax,when using debt capital instead of using only their own capital, than they must do. The theory argues that the more debt is, the more a firm’s value is created. However, in 1976, Jensen and Meckling identified the existence of the agency problem. They proposed that there are two kinds of agency costs - agency costs of equity and debt. The agency costs of equity are due to conflicts between managers and shareholders. However, the agency costs of debt arise due to conflicts between shareholders and debt-holders. The trade off theory indicates the exposure of the firm to bankruptcy and agency cost against tax…show more content…
In Proposition I, M&M assumes that a perfect capital market exists: which implies that no taxes, transaction costs (implication: the borrowing rate is equal to the lending rate) or bankruptcy costs are present, and information is symmetric, meaning companies and investors have the same information. When the condition of a perfect capital market is fulfilled Modigliani and Miller claims that the amount of debt in the firm’s capital structure did not affect the value of the firm and, therefore, firms did not have an optimal capital

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