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Modern capital structure theory started in 1958 by

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Unformatted text preview: Modern capital structure theory started in 1958 by professors Franco Modigliani and Merton Miller (they have been called MM for short) when the published an article which has been called on of the most influential articles in finance ever written. MM has proven, under a set of assumptions, that a firms’ value should not be affected by the capital structure of the firm and that it does not matter how a firm finances itself. The assumptions that MM used to justified its theory is debatable some of the assumptions are if there is not brokerage cost, no taxes and no bankruptcy cost just to name a few. MM work was the start of modern capital structure theory over the past decades many have tried to create a more realistic working theory of capital structure that would work. Over the years MM has relaxed some of its earlier assumptions the first was the issue of taxes. MM recognized the need for corporate taxes so that they could deduct the interest payments as an expense. The assumption of Bankruptcy has been proven to be wrong because it can costly to the firm even the possibility of bankruptcy cast a firm millions of dollars in lost revenue because suppliers would stop giving credit to the firm and employees would begin to look for new jobs and it could also lead to stock prices falling. These arguments have lead to the development of the Trade-Off theory. The theory implies that the higher you debt is the higher you stock price will become so if you reach 100 percent debt then you would maximize the stock price. The theory works with the tax benefits you receive from expensing the interest of the debt or in other words the government is paying for part of the debt. The Signaling theory is another theory that has been introduced that goes against MM theory because in MM theory that every investor and manager has the same information available to them but the signaling theory says that managers have better information about their firm then investors do. The managers of the firm know the company and the industry better the outside investors. If company Green Way Inc. wanted to introduce a new product into the make but it needs funding to build a new plant, but if the mangers know that a different company is already in production a new product then it could cut down profits from the new product and if they used debt to finance the plant then would cut down on its bottom line. If they brought in new investors to fund the new plant then their bottom line would be safe and the new product would increase the firm’s sales. The final idea of capital structure theory is by using debt financing you are able to keep management in line. If a firm has no debt and excess of cash then management can use this cash to fund its own pet projects or buy private jets or company cars for their own usage which would add little value to the stock price. Firms most reduce excess cash; it can do this by issuing bigger dividends or stock repurchase and can invest the cash in bonds or stocks of other firms. dividends or stock repurchase and can invest the cash in bonds or stocks of other firms....
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