Question

Explain in words the logic behind Miller’s theory of capital structure. How does this theory apply in Canada?

Answer 1

As per this theory, the valuation of a firm do not depends on its capital structure. The firm value do not depends on its debt and equity combination or its leverage capacity. Its value purely depends on its earning capacity and its ability to earn profits from the market or operating profits of the firm. The logic behind this is

• Markets are efficient in nature
• there are no income taxes
• any amount of investments can be made or withdraw from the market
• No inflation and no tax on dividends

It explains that, the value of the firm purely depends on its operating abilities, how quickly or accurately takes decisions related to investment into projects, and other operating abilities of a firm.

The same is applicable to the companies in Canada or in some other nation. As per this model, the firms which balance their earnings with risk, can generate higher returns and resulted in higher firm value and vice versa. Those firms, which can not balance these two, may resulted in poor operations, poor in sales and margins too.