There is no doubt that the weighing of capital sources, dividend payout policy, and assessment of tax rates is necessary during corporate financing purchase and overall capital budgeting. However, Modigliani and Miller consider these considerations irrelevant since they are of the opinion that the capital structure of the organization is immaterial to the firms’ valuations (Modiglianu & Miller, 1958). According to Modigliani and Miller, the operating profit of the organization that determines the value of the market. Besides, they argued that the value of the market of the organization is determined by the investment risks as well as the future growth prospect. Their argument is contrary to what capital theory advocates support i.e., a company’s value is driven by its applied capital structure or the firm’s financing decision. This means that the company with a mix of equity (leverage company) and debt is valued the same as the company with wholly financed by equity (unleveraged firm) (Miller & Modigliani, 1961).
The weighted Average Cost of Capital refers to the average price of return that a firm should pay to creditors and shareholders. Financial analysts typically focus on a company’s total capitalization, which is the capital structure or mix of extended- run sources of finance used by the company. The firm’s capitalization consists of bonds, preference shares, and common stock. To estimate the Weighted Average Cost of Capital, one needs to identify the capital constitution mix and the cost of all the sources of funds utilized. The vital assumption in any system of weighting is that the company will increase capital in the specified proportions. These firms hike funds marginally to make incremental investments in the latest projects. Thus the capital cost of the marginal is used wholly in the firm instead of using the firm’s capital in general.
Replies
Albert Aini
This suggests that a firm with high growth prospect have a higher market value and the stock price will equally be high. The principles by Modigliani and Miller relies on the assumption that debt financing does not affect the company involved, borrowing cost for the investor is the same, there is the asymmetry of information, there is no bankruptcy cost, the transaction cost of selling as well as buying securities and no taxes.
The approach of Modigliani and Miller was based on two propositions without taxes: Suggestion 1: The structure of the capital does not influence the company’s valuation, such as leveraging the firm does not increase its value of the market. Proposition 2: This is different from the first proposition in the sense that it takes up that debt shareholder possesses an upper-hand provided the claim on earnings is apprehensive. This means that financial leverage is in direct proportion to the cost of equity. I agree with this approach in the sense that Modigliani and Miller provide a clear benchmark where the dividend policies and capital structure don’t affect the company value.
Kitty Yang
The work of Modigliani-Miller (hereinafter MM) is one of the most discussed and cited in the field of corporate finance. The work of MM was subjected to quite severe criticism, and the authors had to “hold the punch,” which they did an excellent job of publishing answers and explanations to their opponents. First of all, the criticism concerned the fact that the assumptions in the model are not fulfilled in practice. The central premise of MM is that securities trading are carried out in perfect capital markets, since it is in such a market with its characteristic properties that arbitrage transactions are possible when investors sell revalued shares and buy undervalued ones, as a result of which equilibrium is restored. Moreover, it was the possibility of an arbitration transaction that was criticized. Besides, MM assumed that legal entities and individuals have equal access to the markets; therefore, both private investors and corporations can easily issue the same securities.