Modigliani And Miller Theory Analysis

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MODIGLIANI AND MILLERS THEORIES AND ITS WEAKNESS Arnold (2013) stated that financial economists Modigliani and Millers created a simplified model for capital structure decision by making some assumptions in 1958 (pp.830). The assumptions are that there is no taxation, perfect capital markets with perfect information available to all economic agents and no transaction costs, no costs of financial distress and liquidation, firms can be classified into distinct risk classes and individuals can borrow as cheaply as corporations (Arnold 2013 pp. 830). There are 3 propositions. Villamil (n.d) mentioned that the first proposition is that a firm’s debt-equity ratio does not affect its market value. The equation should be V = C1 / WACC. The WACC keep constant as the cost of capital increases and totally offset the effect of cheaper debt. Therefore, the gearing level will not be changed (Arnold 2013 pp. 830). The second proposition establishes that the expected rate of return on equity rises proportionately with the gearing (Arnold 2013 pp. 833). In this proposition, as the firm try to increase debt levels to get a higher level of return, risk of shareholders’ investment will increase. The…show more content…
It suggests that there is no optimal capital structure and no well-defined target debt to equity. Arnold (2013) mentioned that the theory encourage the company considers to use internal financing to generate funds and avoid issuing stock unless absolutely necessary (pp. 842). Firstly, firm will use the storage of retained earnings to finance investment. When the investment needs more funds, company will use debt financing, and issue equity lastly if it still need more funds. According to Modugu (2013), the financial environment is depended on the extent perceived asymmetry information (pp. 14). The following chart is showed how to generate funds according to pecking order

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