Theoretical Literature Review: Irrelevant And Relevant Theory

2.1 Introduction

This section looks at theoretical literature review, empirical literature review and summary of literature review.

2.2 Theoretical literature Review

2.2.1 Irrelevant and Relevant Theory

Modigliani and Miller (MM), 1958 illustrates that under certain key assumptions, firm’s value is unaffected by its capital structure. Capital market is assumes to be perfect in Modigliani and Miller’s world, where insiders and outsiders have free access to information; no transaction cost, bankruptcy cost and no taxation exist; equity and debt choice become irrelevant and internal and external funds can be perfectly substituted. The M-M theory (1958) argues that the value of a firm should not depend on its capital structure. The theory argued further that a firm should have the same market value and the same Weighted Average Cost of Capital (WACC) at all capital structure levels because the value of a company should depend on the return and risks of its operation and not on the way it finances those operations. Miller brought forward the next version of irrelevance theory of capital structure. He appealed that, capital structure decisions of firms with both corporate and personal taxes circumstances are irrelevant (Miller 1977).

If these key assumptions are relaxed, capital structure may become relevant to the firm’s value. So, research efforts have been contributed to relaxing the ideal assumptions and describing the consequences. This theory was criticized on the ground