Question

If a firm is financially healthy, why might it want to avoid issuing new shares of stock?

If a firm is financially distressed, why might it want to avoid issuing new shares of stock?

Please answer these questions using perfect market assumptions of Modigliani and Miller and identify which assumption is invalid for each question

Answer 1

The following can be considered as the assumptions of the Modigliani and Miller theory-

1. The markets are only Perfect capital markets;
2. The investors are fully aware and are very rational;
3. There exists no transaction costs; floatation cost.
4. No single investor can influence market price of securities.

If a firm is financially healthy, it might want to avoid issuing new shares of stock because it may not consider it prudent to dilute its ownership rights.In this case the assumption that the markets are only Perfect capital markets. There exists a certain advantage to the company for its strong financial health.

If a firm is financially distressed, it might it want to avoid issuing new shares of stock because it may have to incur costs of listing and issuing the stocks. In this case the assumption that there are no transaction or floatation costs holds invalid.