The Modigliani-Miller Theorem, Essay Example

The Modigliani-Miller Theorem (M&M) is a theory of capital structure that encourage financial specialists to come deduce the standards by which capital structure would be relevant. Even today, it is important to conduct M&M research because it provides us important and useful information about corporate finance; this can be done by uses three different steps that can help us identify the exact characteristics that will allow us to analysis and assess a financial firm’s structure.

Previous research utilizing static trade-off models has shown than an ideal optimal capital structure is possible. A financial firm should generally set a target debt level and take whatever steps it deems necessary to reach this goal; it does so by determining both the advantages and disadvantages of debt. Although it seems that debt is negative and that companies should never accrue it, it is important to consider that debt can occur when a company takes out a loan to build its business, which is considered an advantage. In this sense, by accumulating more debt, a company may accumulate more profit; in some situations, this may allow a company to avoid declaring bankruptcy. A second advantage of accumulating debt is noticeable during tax season; interest payments on loans are tax deductible, making debt again, a benefit rather than a disadvantage. If a company would like to cash in on these advantages, it should remember to pay back the loans after some time; too much debt may increase the odds of default and bankruptcy. As long as the company plays this game wisely, however, it should continue to be at an advantage.

Another important financial theory was created by Myers and Majluf in 1984 and is known as the “pecking order theory”. This idea contradicts the M&M theory because it assumes that suggests that finance companies don’t have leverage targets. The theory provides an alternative plan to debt accumulation by supporting project funding from cash that was initially generated within the business. The main sources of these internal funds are retained earnings and depreciation expenses. It is important to note that the company will only resort to debt as a source of funding if not enough money is accumulated from these two aforementioned methods. Myers and Majluf justify the use of retained earnings, depreciation expenses, and debt based on the principle of financing costs. As an absolute last resort, users of the “pecking order theory” can use equity to raise funds although this is the most costly way of going about this.

The major difference between the “pecking order theory” and the “static trade-off theory” is that in the former, there is no established hierarchy in determining which methods should be used to raise funds; the major decision that must be made with the “static trade-off theory” is whether funds should be raised from within the company or outside it.

The third financial theory that will be discussed is known as the “agency cost theory” which states that an idea capital structure can be established by making costs as small as possible. This is done by keeping track of the total amount of money spent, the costs of dealing with third parties, and the loss of money associated with these two events. This theory claims that agency costs are the most important in making financial decisions because disagreements may occur between people who are responsible for the debt and the shareholders. It is possible that debt may help temporarily fix agency problems; to do so, companies must establish an ideal debt level that it is not willing to go beyond. It is important to note that in practice, this ideal level may not stay fixed, so the company needs to come up with ways to either keep it at the set level, or determine what to do if this falters. Professionals recommend we do this by observing past trends.