The Modigliani and Miller theories are based on several unrealistic assumptions
ID: 2617738 • Letter: T
Question
The Modigliani and Miller theories are based on several unrealistic assumptions about debt financing. In reality, there are costs, taxes, and other factors associated with debt financing. These costs or effects have led to several theories that explain the impact of these factors on the capital structure of a firm. Based on your understanding of the trade-off theory, what kind of firms are likely to use more leverage? Firms with volatile earnings Firms with stable earnings Based on your understanding of the capital structure theories, identify the best option for the missing part of the statement. Option 1 Option 2 According to signalling theory, a firm with a very positive outlook might tend to use debt financing ???? the normal target capital structure Beyond Equal to A leveraged buyout (LB0) helps the firm 2222both its excess cash flows and managers' temptation to incur wasteful expenses. Reduce Increase According to pecking-order hypothesis, a is likely to use ?7?7 debt than a less Less More Several dominant theories try to explain why financial managers make the capital structure decisions that they do. The following statement describes one such theory Consider this case: The firm's debt-equity decision finds the optimal balance between the interest tax shield benefits of debt and the costs of financial distress associated with issuing debt. financing tdentify which of the two theories is described by the statement. O Pecking-order hypothesis O Trade-off theoryExplanation / Answer
1. The trade-off theory of capital structure is the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. An important purpose of the theory is to explain the fact that corporations usually are financed partly with debt and partly with equity. It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs.
Based on the aforesaid FIRM WITH STABLE EARNINGS are more likely to use leverage i.e debt financing .
2. By definition Debt signaling is a theory that correlates the future performance of a company’s stock with any announcements made regarding its debt. Announcements typically made about a company taking debt are seen as positive news. Thus a firm with more positive outlook will tend to use debt financing BEYOND normal target capital structure.
3.By definition Leveraged buyout (LBO) is a financial transaction in which a company is purchased with a combination of equity and debt, such that the company's cash flow is the collateral used to secure and repay the borrowed money. The use of debt, which has a lower cost of capital than equity, serves to reduce the overall cost of financing the acquisition. Thus it helps to REDUCE the excess cash flows and tempatation to incur wasteful expenses. because repayment of loan is from this generated cash flow.
4.Pecking order theory basically states that the cost of financing increases with asymmetric information. Financing comes from internal funds, debt, and new equity. When it comes to methods of raising capital, companies will prefer internal financing, debt, and then issuing new equity, respectively. Thus a profitable firm is LESS likely to use debt than a less profitable firm.