Capital Structure and Firm Value Assignment Example | Topics and Well Written Essays - 3000 words - 1

Capital Structure and Firm Value - Assignment Example The perfect capital markets are not characterised by any market frictions like trading costs, taxes and the information is easily transmitted between the investors and the managers. M&M made a clear distinction between the financial risk and business risk faced by a firm. While the financial risk refers to the choice of risk distribution between the bondholders and shareholders, the business risk refers to the uncertainty of cash flows of the business. It has been pointed out by Miller and Modigliani that changes in leverage does not cast any significant influence on the cash flows generated by the business. Therefore changes in leverage cannot alter the value of the firm. According to them leverage simply defines the distribution of cash flows between the bondholders and the shareholders. As per M&M model the value of levered firm (VL) is equal to the value of unlevered firm (VU). Suppose there are two companies- Company 1 and Company2. It is assumed that the two companies have identical cash flows and belong to same risk profile. The difference between the two companies is with respect to financing. M&M state that the market value of the two companies is same. Suppose the pay-off of Company 1 in good state is 160 and in bad state is 50. This company is financed only by the equity mode of financing. Similarly the payoff of Company 2 is 160 in good state and 50 in bad state. It is financed by the combination of debt and equity. Suppose the total debt of Company 2 is $60 and its market value is $50; the market value of its equity is $50. Then the value of the Company 2 is- Modigliani and Miller have stated that the â€Å"value of leveraged firm† is equal to the sum of â€Å"the value of unleveraged firm plus tax advantage of debt†. Miller modified the equation obtained under MM Proposition without taxes (Lee, et al., 2009, p.208).