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The document discusses capital structure theory as studied by Miller and Modigliani in the 1950s. They hypothesized that in perfect markets, the financial structure a company uses does not impact its value. However, their key assumptions did not consider taxes or bankruptcy costs. Later work incorporated these factors, finding an optimal capital structure where tax benefits of debt maximize firm value up until bankruptcy risks increase. In summary, capital structure is irrelevant without taxes but debt provides tax shields, lowering a company's overall financing costs.
The document discusses capital structure theory as studied by Miller and Modigliani in the 1950s. They hypothesized that in perfect markets, the financial structure a company uses does not impact its value. However, their key assumptions did not consider taxes or bankruptcy costs. Later work incorporated these factors, finding an optimal capital structure where tax benefits of debt maximize firm value up until bankruptcy risks increase. In summary, capital structure is irrelevant without taxes but debt provides tax shields, lowering a company's overall financing costs.
The document discusses capital structure theory as studied by Miller and Modigliani in the 1950s. They hypothesized that in perfect markets, the financial structure a company uses does not impact its value. However, their key assumptions did not consider taxes or bankruptcy costs. Later work incorporated these factors, finding an optimal capital structure where tax benefits of debt maximize firm value up until bankruptcy risks increase. In summary, capital structure is irrelevant without taxes but debt provides tax shields, lowering a company's overall financing costs.
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Capital Structure Theory
1. Studied intensely by Miller & Modigliani (1950s professors) 2. Hypothesised that in perfect markets - does not matter what financial structure a company uses to finance operations 3. Market value determined by earning power & risk of assets 4. Value = independent of way it chooses to finance/distribute dividends 5. Key assumptions ⁃ No taxes ⁃ No transaction costs ⁃ No bankruptcy costs ⁃ Symmetry of market information ⁃ No effect of debt on company’s earnings before interest and taxes 7. M&M’s capital structure irrelevance proposition 8. WACC remains constant w/ changes in companies capital structure 9. No matter how a company borrows, there are no tax benefits 10. Stock price also no influenced by capital structure 11. In latter papers, taxes and bankruptcy costs are included by M&M 12. M&M tradeoff theory of leverage 13. Benefits of leverage until optimum capital structure is reached 14. Recognises tax benefits from interest payments (tax deductible) 15. In summary ⁃ Theory w/out taxes says firms relative proportions of debt & equity do not matter ⁃ W/ taxes it says firms with greater proportion of debt is more valuable because of the tax shield 16. In summary 2 ⁃ Capital structure is irrelevant so changes in debt-equity do not affect WACC (no taxes) ⁃ W/ taxes it does ⁃ Greater proportion of debt = lowers company’s WACC
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