Capital Structure Is Irrelevant For Studying Corporate Finance Example For Free

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What is capital structure? Capital structure is the mixture of sources of funds in cluding long-term debt, specific short-term debt, common equity and preferred equity but excluding all short term credit.. Leverage firm means that firm uses to finance its assets. A firm with a lot of debt in its capital structure is said to be highly levered. A firm with no debt, it is called unleveraged. Difference industies have difference capital structure. Optimal capital structure is how to balance the cost of an enterprise to find a balance between the point of maximizing the value of the company or the cost of capital minimization. Due to changes in capital structure will affect the reported return on equity and stock prices, so the choice of capital structure is a very important decision Modigliani-Miller Theorem is a financial theory suggests that the market value of a firm is determined by its profitability, risk of the corporate and its related assets, it is an independent way to finance its investments or distribute dividends. The basic idea of the theorem is, the firm value will not affect whether a firm finances with debt or equity, under certain assumptions. The MM irrelevance proposition is developed in a world with perfect markets, so that there are no conflicts. In particular, there are no transactions costs, no taxes and no costs are incurred to induce mangers to maximize the value of the firm. In 1958, Franco Modigliani and Merton Miller (MM) proved, under a restrictive set of assumptions including zero taxes, that capital structure is irrelevant. The first irrelevance proposition, Proposition I in the 1958 paper titled “The Cost of Capital, Corporation Finance and the Theory of Investment” published in the American Economic Review, states that “the market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the (…) appropriate to its class.” (Modigliani and Miller, 1958, p.268). That is, a firm’s value and cost of capital are not affected by its financing mix. A firm’s value will be determined by its project cash flows. The cost of capital will remain constant with leverage. As a firm increases its financial leverage, the cost of equity will increase just enough to offset any gains to the leverage. The method of arbitrage can be used to prove Proposition I. MM did not develop arbitrage but they made it a foundation of modern finance. MM assume that Financial markets are perfect and show that ” if Proposition I did not hold, an investor could buy and sell stocks and bonds in such a way as to exchange one income stream for another stream, identical in all relevant respects buy selling at a lower price. The exchange would therefore be advantageous to the investor quite independently of his attitudes toward risk. As investors exploit these arbitrage opportunities, the value of the overpriced shares will fall and that of the underpriced shares will rise, thereby tending to eliminate the discrepancy between the market values of the firms.”

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