Modigliani and Miller - what is the predicted effect of changes in capital structure on the firm value - 1958 model
WITHOUT TAX
The value of the company is not determined by financing - instead by investment decisions
Total market value is independent of capital structure
Critically evaluate trade off theory
Firms do borrow but not with ultra high gearing - balancing cost vs benefits of debt to achieve optimum capital structure
- it can be difficult to quantify cost and benefit of debt
- reflects how in the real world companies have to strike a balance between cost of debt and tax
- companies have target leverage ratios in real life - this reflects it
- assumes rational decision making
Critically evaluate pecking order theory?
- shows how companies are risk averse - prefer retained earnings to other finance sources
- internal over external
- ignores the fact that equity issuance is not always the last resort - lots of companies use it to raise capital
- doesn’t rely on the concept of optimal debt-equity ratio - more flexible and realistic
- does not require a firm to maintain optimum capital structure
Discuss hidden costs of debt
COST OF FINANCIAL DISTRESS:
- loss of confidence from stakeholders - loss of supplier and customer good will
UNCERTAINTY AS TO LONG TERM SURVIVAL
- low moral in staff
- reputational risk
LOSS OF FINANCIAL FLEXIBILITY
- excessive attention to short term liquidity
- high borrowing costs if credit rating deteriorates
- reduces ability to to raise funds quickly
AGENCY COSTS
- agency costs - underinvestment - skip good projects if returns are primarily being returned to creditors
- accountancy costs etc
- effort spent managing lender relationships
Modigliani and Miller - what is the predicted effect of changes in capital structure on the firm value - 1963 model
WITH TAXES
Impact of taxes cannot be ignored
Interest on debt is tax deductible so firms should borrow as much as possible
Tax shield makes debt cheap
High gearing changes the capital structure (reduces WACC) and increases the firm value as interest payments reduce taxable income
