Question

a)summarize the Modigiani-Miller 1958 capital structure theory as described within the capital structure theory:A current perspective
b) Summarize your interpretation of optimal capital structure as described within the Capital structure theory:A current perspective.

Answer 1

Question a)

Modigiani-Miller 1958 capital structure theory:

The MM theory is mainly based on the very assumption that the market value of a Company is fairly priced based on its future earnings and it does not depend on the capital structure employed by the Company, i.e, debt or equity or preference share capital.

Propositions of the Theory:

1. Proposition 1: VL= VU, where,  

• VU = Value of the unlevered firm (financing only through equity)
• VL = Value of the levered firm (financing through a mix of debt and equity)

the value of a company is not affected by its capital structure. Also, since in perfectly efficient markest, there are no taxes, hence a Company does not gain by paying up tax deductible interest payments.

2. Proposition 2: re= ra + D/E(ra-rd)   

Where:

• rE = Cost of levered equity
• ra = Cost of unlevered equity
• rD = Cost of debt
• D/E = Debt-to-equity ratio

The company's cost of equity (return) has a direct relation with the company's leverage level. Higher the financial risk of the Company, higher will be the cost of equity (return expected by the equity shareholders).