Question

The answer should have some critical thinking and class concepts -(Corporate Financial Management). Do not exceed 650 words. You are allowed to cite websites and have references. Thanks.

In your own words, describe the M&M theory i.e. choose one of the two propositions, include how it benefits/affects the company and/or the shareholders.

Answer 1

As per M&M when we increase the proportion of debt in our capital structure overall cost of capital structure tries to reduce but at the same time because of increase in the proportion of debt company becomes financially risky and this increases the expectation of equity shareholders and also the cost of equity. This will again push the overall cost of capital upward. The combined effect of the above two will make the overall cost of capital constant.

The assumptions of M&M theory are:

1. There are no taxes

2. Kd is constant

3. Ko is constant

4. An investor can borrow at the same rate at which the firm borrows