Question

What are the main assumptions and the basic conclusion of the original Modigliani and Miller proposition on the capital structure? Explain.

short and correct answer please

Answer 1

assumptions

1. Competent capital markets
2. No transferring cost of securities
3. Investor can easily get loan on securities
4. General business risk
5. There is no retention of earning all earning is to be distributed among shareholders as a dividend.
6. No Texas.

Explanation:-

According to this theory the capital structure of company is does not affect to the value of the firm that means the proportion of debt and equity does not impact the overall value of firm. Let's understand how. debentures are considered as risk to the form because on debenture firm has to pay interest every year regardless of earning of the company. So normally people things that as firm increases Debt in the capital structure the overall cost of capital structure decrease and the value of firm increases but as debt increases in the capital structure Expectations of the equity shareholders increases because the overall risk of the firm is increased because of the Financial leverage taken by the firm organisation. So the required return by equity shareholders increases. And when we calculate the WACC of new leveraged firm at one side the cost is decreasing due to the increase in the proportion of debt because that is cheaper source of finance but at other side the expectations of equity shareholders increases and the cost of equity is also increases and due to that there is no change in WACC. And there is no change in the value of the firm because the earnings of the firm will be discounted at higher rate.

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