Corporate Finance: The Modigliani Miller Proposition I

1595 Words4 Pages
bulb-icon

Recommended: Primary factors influencing capital structure decision

Introduction
According to my research in corporate finance, capital structures decision is ranked as the most influential issue facing executives at the management level. The corporate finance is described as an area of finance that deals with financial decisions and tools and analytics used in making the decisions. The discipline is divided into long-term and short-term decisions and techniques with their primary goal being maximization of the corporate value while at the same time in management of the firm’s financial risks. Corporate finance is a theory, process and techniques which corporations use to invest, finance and make dividend decisions and thus they make decisions on what projects to invest, then they figure out how to finance …show more content…

However, the firm’s value is determined by the real assets and not by the securities issues. In short, it is assumed that the decisions involving capital structure are very irrelevant as long as the firm takes investment decisions as they are set (McCauley, 2004).
Miller and Modigliani in the year 1958 made an explanation that the theorem was proven in the absence of taxes. The theorem was/is made up of two propositions which …show more content…

The debt-equity ratio is usually used to show the amount of debt that a company uses to finance its assets which are relative to the amount that is represented in the shareholder equity. In accounting and finance, the term equity is defined as the difference between the value of a firm's assets and the given costs of liabilities of the owned asset. Shareholder equity, however, is the equity of a given company that is divided among shareholders who appear in a common market or stock. The formula used to calculate the debt equity ratio is; Debt-equity ratio=total liabilities/shareholder equity. The result is expressed as a percentage. The form of D/E is usually referred to as gearing or risk.
Given that a firm's debt-equity ratio is used to measure the debt of a company which is relative to the value of the firm’s stock, this tool is often used to gauge the extent in which the firm takes on debts as a means of leveraging. An increase in the debt equity ratio means that a firm has been in an aggressive mode in making finances for its growth with debts. When there are aggressive leveraging practices, it means that the firm is associated with high levels of

Show More
Related

  • Analysis Of Wendy's Corporation And Bob Evans Farms

    1011 Words  | 3 Pages

    These ratios can be used to determine the most desirable company to grant a loan to between Wendy’s and Bob Evans. Wendy’s has a debt to assets ratio of 34.93% while Bob Evans is 43.68%. When it comes to debt to asset ratios, the company with the lower percentage has the lowest risk. Therefore, Wendy’s is more desirable than Bob Evans. In the area of debt to equity ratios, Wendy’s comes in at 84.31% while Bob Evans comes in at 118.71%. Like debt to assets, a low debt to equity ratio indicates less risk in a company. Again, Wendy’s is the less risky company. Finally, Wendy’s has a times interest earned ratio of 4.86 while Bob Evans owns a 3.78. Unlike the previous two ratios, times interest earned ratio is measured on a scale of 1 to 5. The closer the ratio is to 5, the less risky a company is. From the view of a banker, any ratio over 2.5 is an acceptable risk. Both companies are an acceptable risk, however, Wendy’s is once again more desirable. Based on these findings, Wendy’s is the better choice for banks to loan money to because of the lower level of

    Read More

  • Bestcare Health Maintenance Organization Net Working Capital

    579 Words  | 2 Pages

    Net working capital represents organization’s operating liquidity. In order to compute the net working capital, total current assets are divided from total current liabilities. When there is sufficient excess of current assets over current liabilities, an organization might be considered sufficiently liquid. Another ratio that helps in assessing the operating liquidity of as company is a current ratio. The ratio is calculated by dividing the total current assets over total current liabilities. When the current ratio is high, the organization has enough of current assets to pay for the liabilities. Yet, another mean of calculating the organization’s debt-paying ability is the debt ratio. To calculate the ratio, total liabilities are divided by total assets. The computation gives information on what proportion of organization’s assets is financed by a debt, and what is the entity’s ability to pay for current and long term liabilities. Lower debt ratio is better, because the low liabilities require low debt payments. To be able to lend money, an organization’s current ratio has to fall above a certain level, also the debt ratio cannot rise above a certain threshold. Otherwise, the entity will not be able to lend money or will have to pay high penalties. The following steps can be undertaken by a company to keep the debt ratio within normal

    Read More

  • Home Depot: Financial Leverage Analysis

    941 Words  | 2 Pages

    Financial Leverage Analysis Regarding financial leverage, the debt percentage ratio increased from 84.95% to 89.92%, indicating an increase in the amount of The Home Depot’s assets that are financed with debt. The debt to equity ratio drastically increased, from 5.65 to 8.92, showing a drastically increased amount of financial leverage in the company. This may not always be good for a company, as it means there is a very large amount of debt. However, the quick ratio had virtually no change (decreased by .01), showing that an increase in debt and financial leverage did not affect cash and cash equivalents. In fact, cash and cash equivalents increased, as stated in the above paragraph citing vertical analysis.

    Read More

  • McDonald's & Wendy's Financial Statement Comparison

    1687 Words  | 4 Pages

    When comparing the debt-to-assets ratio of McDonalds and Wendys, you have to divide the firms total liabilities by their total assets. Essentially, the debt-to-assets ratio is the primary indicator of the firms debt management. As the ratio increases or decreases, it indicates the firms changing reliance on borrowed resources. The lower the ratio the more efficient the firm will be able to liquidate its assets if operations were discontinued, and debts needed to be collected. In 2005 Wendy's had $2,076,043 worth in total assets and $846,264 in total liabilities. When divided, Wendys has the lower ratio of the two competitors at 40%. This means that they would take losses of 40% if operations were shut down, and the cash received from valuable assets would still be sufficient to pay off the entire debt. It also means that 40% of Wendys assets are made through debt. McDonalds in 2005 had $12,545.3 (in millions) of total liabilities and $22,534.5 (in millions) of total assets. After doing the math, McDonalds ends up with a ratio of 56% which is higher than Wendys by sixteen percent. This means that there is more default on McDonalds liabilities, which can be a costly event from lenders perspective. McDonalds makes 56% of all its assets through debt. In reality, its not good to have a debt-to-assets ratio over 50%. Its also not good to have a debt-to-assets ratio that is too low because...

    Read More

  • Home Depot & Capital Structure

    987 Words  | 2 Pages

    Finding the perfect capital structure in terms of risk and reward can ensure a company meets shareholder expectations and protects a firm in times of recession. Capital structure refers to how a business puts its money to “work”. The two forms of capital structure are equity capital and debt capital. Both have their benefits and limitations. Striking that perfect balance between the two can mean the difference between thriving versus trying to survive.

    Read More

  • Du Pont de Nemours and Company Case Analysis

    1186 Words  | 3 Pages

    The consistent high spending of capital equipment is the first reason why one would recommend reducing the debt to equity ratio. A company with higher levels of debt is less flexible in being able to adjust to new market demands and conditions that require the company to make new products or respond to competition. Looking at the pecking order of financing, issuing new shares to fund capital investing is the last resort and a company that has high levels of debt, must move to the equity side to avoid the risk of bankruptcy. Defaulting on loans occur when increased costs or bad economic conditions lead the firm to have lower net income than the payments on loans. The risk of defaulting on loans and the direct and indirect cost related to defaulting lead firms to prefer lower levels of debt. The financial distress caused by additional leverage can lead to lower cash flows available to all investors, lower than if the firm was financed by equity only. Additionally, the high debt ratio that Du Pont incurred also led to them dropping from a AAA bond rating to a AA bond Rating. Although the likelihood of not being able to acquire loans would be minimal, there are increased interest costs with having a lower bond rating. The lower bond rating signals to investors that the firm is more likely to default than if it had a higher (AAA) bond rating.

    Read More

  • Summary Of Target Corporation Capital Structure

    1753 Words  | 4 Pages

    The capital structure decisions for Target Inc. are significant since the profitability of the firm is specifically influenced by this decision. Profit maximization is part of the wealth creation process and wealth maximization can be a lengthy process for financial managers. Profits affect the value of the firm and it is expressed in the value of stock. Cost of capital is how investors evaluate weighted average cost of capital (WACC). Capital structure ratios help investors gauge the level of risk that a company is taking on through financing. While Target

    Read More

  • Critically assess the Pecking Order Theory of Capital Structure

    1779 Words  | 4 Pages

    There is no universal theory of the debt-equity choice, and no reason to expect one. In this essay I will critically assess the Pecking Order Theory of capital structure with reference and comparison of publicly listed companies. The pecking order theory says that the firm will borrow, rather than issuing equity, when internal cash flow is not sufficient to fund capital expenditures. This theory explains why firms prefer internal rather than external financing which is due to adverse selection, asymmetry of information, and agency costs (Frank & Goyal, 2003). The trade-off theory comes from the pecking order theory it is an unintentional outcome of companies following the pecking-order theory. This explains that firms strive to achieve an optimal capital structure by using a mixture debt and equity known to act as an advantage leverage. Modigliani and Miller (1958) showed that the decisions firms make when choosing between debt and equity financing has no material effects on the value of the firm or on the cost or availability of capital. They assumed perfect and frictionless capital markets, in which financial innovation would quickly extinguish any deviation from their predicted equilibrium.

    Read More

  • The Royal Mail 's Capital Structure

    1988 Words  | 4 Pages

    Assessing the capital structure of any firm is important for investors attempting to determine if...

    Read More

  • Accounting: The Equation, Assets = Liabilities + Stockholders Equity

    627 Words  | 2 Pages

    One of the largest concepts in accounting is the equation, Assets = Liabilities + Stockholders Equity. Assets are economic resources owned by the company such as cash and inventory. Assets can be physical property such as machinery, or they can be non-material things like trademarks or patents. Liabilities are something a company is indebted to. Stockholder equities are a source of funding from stockholders. Stockholder’s equity is the money that would remain if a company paid off all of its liabilities and sold all of its assets. The relationship and equation creat...

    Read More

  • Financial Analysis of Pepsi Co, Inc. and The Coca-Cola Companies

    1757 Words  | 4 Pages

    ... show that the company is growing and expanding, property and inventory, as a percentage of assets, should be increasing instead of decreasing. More property and inventory, if it is not owned by creditors, would also decrease their debt to total assets ratio.

    Read More

  • Stock Valuation Method

    753 Words  | 2 Pages

    The debt-to-equity ratio (D/E) is an economical ratio indicating the part of shareholders ' equity and debt utilized to finance a firm 's assets. To calculate, debt/equity ratio: D/E = Debt (liabilities) / equity.

    Read More

  • Irrelevance Theory Essay

    1367 Words  | 3 Pages

    We cannot determine the optimal capital structure for a given company, but we know that it depends on the following:

    Read More

  • The Purpose of Financial Statements

    1286 Words  | 3 Pages

    Ÿ Capital structure/investment - This information is taking from the Balance sheet, but also from the Profit and Loss Account. This is examining the sources of finance the company has used and also looking at it as a potential investment opportunity. There are certain features, which must be present if financial information is to meet the needs of the user. The two most important features are that: Ÿ The information should be relevant to those who are using it.

    Read More

  • Advantages And Disadvantages Of Capital Structure

    1186 Words  | 3 Pages

    The capital structure of a firm is the way in which it decides to finance its operations from various funds, comprising debt, such as bonds and outstanding loans, and equity, including stock and retained earnings. In the long term, firms seek to find the optimal debt-equity ratio. This essay will explore the advantages and disadvantages of different capital structure mixes, and consider whether this has any relevance to firm value in theory and in reality.

    Read More

More about Corporate Finance: The Modigliani Miller Proposition I

Open Document