Original question: modigliani and miller: a challenge to capital

ORIGINAL QUESTION:

Modigliani and Miller: A Challenge to Capital Budgeting Strategies

Financing corporate purchases and overall capital budgeting usually requires the finance manager to assess tax rates, dividend payout policy, weighting of capital sources, and more. However, the Modigliani and Miller propositions state that, in most situations, it does not matter if the firm’s capital is raised by issuing stock or selling debt. As a student you might assume studies of capital budgeting strategies will no longer be reviewed in coursework. Before coming to that conclusion please discuss the principles presented by Modigliani and Miller and explain your agreement or disagreement.

STUDENT 1 RESPONSE:

The Modigliani-Miller Theorem (M&M) is a financial theory that believes that the market value of a company is determined by their earning power and the risk of their underlying assets and does not have anything to do with how an organization chooses to finance its investments whether it is debt or equity (Ozyasar, 2015). Some of the principles of Modigliani-Miller theorem are no matter how a firm is financed profitability is unaffected by the financing decisions. In order for this theorem to hold true certain things have to also be true like no transaction cost when a firm is issuing stocks or bonds, companies and or investor can borrow money at the same cost and the company will not squander any extra cash they gain from doing business.

I disagree with the Modigliani-Miller theorem because all of the scenarios presented are never true in real life for one whenever a company issues stocks or bonds there will be transaction cost associated with them such as fees and commissions. There is also the idea that borrowing cost have to be equal for individuals and firms which does not happen in real life because a firm will usually have a better credit rating than most individuals which will allow them to borrow money at much better rates than most individual would ever be able to get. Another part of the theorem that usually never happens is that the business must not squander excess cash which would also be unlikely that any one individual has to be taking cash and spending it personally but usually firms will invest excess cash and sometimes these investments will not work out meaning risk have to be taken.

After going over the theorem and applying it to real life it just wouldn’t happen because all of the things that have to take place for companies not to be affected by how they finance their investments will never take place in real life, it is more likely that the exact opposite will happen which makes me totally disagree with Modigliani-Miller.

Paul Boling

References:

Ozyasar, H. (2015). Assumptions of the Modigliani-Miller Theorem. Retrieved 05/18/2016 from

http://smallbusiness.chron.com/assumptions-modiglianimiller-theorem-55674.html

STUDENT 2 RESPONSE:

Prof and Class,

Modigliani and Miller: A Challenge to Capital Budgeting Strategies

Financing corporate purchases and overall capital budgeting usually requires the finance manager to assess tax rates, dividend payout policy, weighting of capital sources, and more. However, the Modigliani and Miller propositions state that, in most situations, it does not matter if the firm’s capital is raised by issuing stock or selling debt. As a student you might assume studies of capital budgeting strategies will no longer be reviewed in coursework. Before coming to that conclusion please discuss the principles presented by Modigliani and Miller and explain your agreement or disagreement.

Modigliani and Miller, two professors in the 1950s, studied capital-structure theory intensely. From their analysis, they developed the capital-structure irrelevance proposition. Essentially, they hypothesized that in perfect markets, it does not matter what capital structure a company uses to finance its operations. They theorized that the market value of a firm is determined by its earning power and by the risk of its underlying assets, and that its value is independent of the way it chooses to finance its investments or distribute dividends

The basic M&M proposition is based on the following key assumptions:

  • No taxes
  • No transaction costs
  • No bankruptcy costs
  • Equivalence in borrowing costs for both companies and investors
  • Symmetry of market information, meaning companies and investors have the same information
  • No effect of debt on a company’s earnings before interest and taxes

Of course, in the real world, there are taxes, transaction costs, bankruptcy costs, differences in borrowing costs, information asymmetries and effects of debt on earnings. To understand how the M&M proposition works after factoring in corporate taxes, however, we must first understand the basics of M&M propositions I and II without taxes.

I agree that there is risk in investing and no matter how big or how small of the amount invested, that there will be underlying costs including taxes, transaction costs, and any and/or bankruptcy costs that may occur in case the business goes under. This is why there must be a professional investment firm involved and legal representation and paperwork drawn up in the case of any unforseen losses.

Read more: Modigliani And Miller’s Capital Structure Theories – Complete Guide To Corporate Finance | Investopedia http://www.investopedia.com/walkthrough/corporate-finance/5/capital-structure/modigliani-miller.aspx#ixzz493fldR00
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