# The Modigliani And Miller Theory Finance Essay

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Date added: 17-06-26

**Type:** Narrative essay

**Category:** Finance Essay

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The Modigliani Miller Theorem is a linchpin of modern corporate finance. At its core, the theorem is an irrelevance proposition: The Modigliani Miller Theorem provides circumstances under which an enterprise's financial decisions are independent on its value. Modigliani (1980, pxiii) explains the Theorem as follows: Ã¢â‚¬Â¦ with well-functioning markets (and neutral taxes) and rational investors, who can 'undo' the corporate financial structure by holding positive or negative amounts of debt, the market value of the firm - debt plus equity - depends only on the income stream generated by its assets. It follows, in particular, that the value of the firm should not be affected by the share of debt in its financial structure or by what will be done with the returns - paid out as dividends or reinvested (profitably). There are four distinct results that are understood from the Modigliani Miller Theorem and they are as follow: The debt-equity ratio does not affect its market value under certain conditions. The second proposition inculcates that a firm's debt-equity ratio is unaffected by its weighted average cost of capital that is the cost of equity capital is a linear function of leverage. Firm's market value is sovereign of its dividend policy. Stock-holders are non-chalant about the firm's financial policy. The modern theory of capital structure started with Modigliani Miller(1958) on the plight of capital structure irrelevance. The distinct results shown above were based on the following assumptions: Market prices cannot be influenced by scale of an individual's transactions that is all investors are price-takers. Firms and investors being market participants can lend or borrow at the same riskless rate. Income taxes are neither paid on the corporate level nor at a personal level. There are no transaction charges or allowances. Investors are all rational wealth-suitors. Enterprises are grouped into " homogeneous risk classes" such that all members of the group obtain the same return. Similar expectations about future company earnings are formulated by investors ( normal probability distribution). The assets of a company that can no longer carry out its business( insolvent) can be sold at full market values.

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