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Question:

According to Miller and Modigliani “Capital Structure Choices affect a Company’s real Investment Policy”. Evaluate this Statement from a Modern Business Perspective with reference to relevant Academic Literature.  
 
 

Answer:

Introduction

The report presented below is on the basis of the study made for the capital structure of the company. The discussion of the structure that should be adopted by the company for better decision making in the investment policies is done. It is divided into three parts. The first part shows the concept of the term capital structure, the importance of debt-equity ratio, and the use of the same. The next part explains the ancient theory of capital structure presented by Miller and Modigliani is explained. It is explained that how the theory was made on some assumptions that are not relevant in the business environment in today’s scenario. The comparison of the theory and the current working situations is discussed in the next part of the report. How is proper capital structuring required for better working of a company is explained in this part of the report. The report covers the possible aspects of explanation along with ancient theory of capital budgeting and its importance in the investment decision made by the companies.

 

Concept

Every company needs funds to grow over all and to incur their operational costs. Various funds are encouraged to raise these funds. The process of raising funds is different in different companies. The fund rising could be done by different combinations of equity share capital or debts. If the company opts the equity base revenue generation than the retained amount would be distributed proportionately to the shareholders by the way of dividend. If the company has a capital structure in which they had borrowed money from market then first preference will be of the repay such outstanding monies then the remaining amount is distributed among the shareholders (Andrikopoulos, 2009).

According to the research made, it was observed that when the company opts for a ratio in which the proportion of debt is more than equity then the growth of the company will be maintained up to a certain level and after that the a point will come where the borrowing have to be included in the cost of the company and this will at the end reduce its market value. In the current scenario, considering the various expenses, it was suggested to invest the money that is borrowed from the market and retain its own money for further diversification (Yang, Chueh and Lee, 2014).

Miller & Modigliani theory of capital budgeting

The theory of Miller & Modigliani was given by two experts in the year 1950. This theory was based on the working conditions and assumptions of a perfect market scenario around. Certain assumptions which were a part of it are:

  • No taxes paid by the companies
  • There is no transactional cost in the buying and selling of the goods and services.
  • There is no bankruptcy cost.
  • There is similarity in the information that is available with the companies and investors. This means that the investors had complete knowledge of the internal affairs of the companies and will take the investment decision accordingly (Wong, 2015).
  • The cost at which the borrowing are made from the market is same for everyone, be it a company or an investor (Brusov et al., 2011).
  • The earnings before the interest and tax will not be effected by the capital structure in which there is more of debt ratio.

According to them the valuation of any company is not relevant to capital structure. The theory further says that the company value is not dependent on what type of capital structure is opted. In fact if the company has higher growth vision and prospects the market value would be high. More shareholders would be attracted for investments (Cheng and Weiss, 2012).

 

The theory worked on two propositions:

It is observed in this theory that the market value of the company is not affected by the capital structure it applies. As there is an assumption that there are no taxes the structure of the company is of no use for the valuation.
 
In a capital structure where the debts ratio is more than the equity, the risk of the equity holders increased which in return decreases the cost of debentures (Hung and Lin, 2014).
 
 

Comparison with the current business perspective:

It is discussed in the report that the theory of Miller & Modigliani was based on some assumption which is not feasible in today’s scenario. The working conditions now, make the theory irrelevant to be practically applied. The capital structure plays an important role in the investment decision of the company.  As the capital structure makes the funds available for the companies for further investments. The debt equity ratio is to be properly maintained by the company (Lam, Zhang and Lee,  2013). If the company is debt oriented then arrangements have to be made to borrow the monies from the market at a reasonable rate of interest. The earning made from the application of the monies borrowed will be used first to payback the borrowed money.

 


The situation of no tax, no transactional cost, no bankruptcy cost does and various other assumptions of the theory not exist in today’s working environment. Hence, the theory stands irrelevant in the current working preferences (Magni, 2010). The capital structure is important to analyse the valuation of the company in the market.

Conclusion

During the research of for the preparation of the report it was observed that a structure which make the company capable of raising funds for investments from the available sourced is to be proportionately managed. The company can do the same opting for an equity oriented structure where the money invested in the operational cost is of the shareholders of the company, or can borrow the same from the market as well. It is also observed that in today’s scenario the theory of Mille aad Modigliani stands irrelevant as the assumptions does not prevails today. The concept of which the theory was built cannot be practised in the business working preferences today.

 

References

Andrikopoulos, A., 2009, Irreversible investment, managerial discretion and optimal capital structure. Journal of Banking and Finance, vol. 33, no 4, pp 709-718.

Brusov, P., Filatova, T., Orehova, N., & Brusova, N., 2011, Weighted average cost of capital in the theory of Modigliani–Miller, modified for a finite lifetime company. Applied Financial Economics, vol. 21, no 11, pp 815-824.

Cheng, J., & Weiss, M., 2012, Capital Structure in the Property-Liability Insurance Industry: Tests of the Tradeoff and Pecking Order Theories. Journal of Insurance Issues, vol. 35, no 1, pp 1-43.

Hung, Chen, & Lin., 2014, The relationship with REITs and bank loans: Capital structure perspectives. Finance Research Letters, vol. 11, no 2, pp 140-152.

Lam, S., Zhang, W., & Lee, R., 2013, The Norm Theory of Capital Structure: International Evidence*. International Review of Finance, vol. 13, no 1, pp 111-135.

Magni, C., 2010, Residual income and value creation: An investigation into the lost-capital paradigm. European Journal of Operational Research, vol. 201, no 2, pp 505-519.

Wong, K., 2015, A regret theory of capital structure. Finance Research Letters, vol. 12, p 48.

Yang, G., Chueh, H., & Lee, C., 2014, examining the theory of capital structure: Signal factor hypothesis. Applied Economics, vol. 46, no 10, pp 1127-1133.

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