CORPORATE FINANCE Essay Example | Topics and Well Written Essays - 1500 words

CORPORATE FINANCE - Essay ExampleIt had been generally assumed that there is an optimal mixture of debt and equity in a firms chapiter organize that results in a shallow, U-shaped average exist-of- big(p) curve. That is to say, the market value of the firm provide rise to a point with an increase in the debt ratio. beyond that point, any increase in the debt ratio get out cause the market value of the firm to decline. (Ariff and Lau, p. 391-410)Precisely, the traditional view states that capital structure may tinge the cost of capital and in that way influence the value of a firm. It holds that the credible or rational use of leverage will decrease the conglomeration cost of capital primarily and therefore also add to value. When leverage turns out to be excessively high, beyond an optimal point, the cost of capital will begin to increase and hence the value will decline. There is no specific recognition of how to measure either a moderate or reasonable or optimal capital st ructure (Ariff and Hassan, p. 11). Some have authorized a moving average of historical capital structure others have accepted an industry ratio. This concept is depicted through Figure 1 belowAlthough the traditional view appears to be substantially correct in relation to recognise real world behavior of capital structure, it suffers from lack of rigorous proof. ... b) The Independence Hypothesis Modigliani and Miller (1958)Modigliani and miller 1were the first to develop a modern hypothesis of capital structure supported by rigorous mathematical proof. The M&M (1958) theory is based on several simplifying assumptionsi. Perfect and frictionless capital markets with investors that behave rationallyii. Individuals can borrow and lend at the same interest rate regardless the amountsiii. No corporate or personal income taxesiv. The firms cost of equity depends upon its business risk classv. Firms issue only risk-free debt and risk equity, and thus there are no bankruptcy costsvi. ru n earnings of the firm are not expected to grow. The original M&M theory holds that the average cost of capital is independent of the firms capital structure and equal to the capitalization rate of an unlevered stream of earnings at the capitalization rate appropriate to its risk class. As a result, the total market value of the firm is independent of its capital structure.Figure 2 Adopted from figure 5 Maugham, 2000, p.1 The original M&M result was obtained assuming perfect capital markets. Subsequent literature has relaxed the underlying assumptions of M&Ms 1958 model. Stiglitz (1969) proved, using a state preference framework that the M&M result (1958) holds with risky debt, so abundant as there are no bankruptcy costs. Hamada (1969), using the CAMP, showed that the M&M result (1958) holds in a world where assets are allowed to have incompatible risk classes. Mossin (1969), using a modified version of Sharpes single-period asset valuation model, showed that in tax less, frictio nless markets where there is no possibility that the firm will go bankrupt, changes in its debt-equity ratio will not alter the total market value of