Two economists from the United States,Franco Modigliani and Merton Miller became famous in the 1960s thanks to an article they had published. The article was called'The cost of capital, corporate finance and investment theory'. This article radically changed the risk assessment investment that could be incurred by a corporation. The two theorems that they presented stated that'the financial structure and dividend policy do not affect the value of a company'.
Thanks to Income taxes, the value of a leveraged firm is equal to the value of a firm without debt. The firm has an interest in debt as far as lenders are willing to provide capital to risk-free rate.
Tags - Franco Modigliani, Merton Miller
[...] In giving this decision-making authority to shareholders, these models illustrate changes in production strategy resulting from the issuance of debt and show that debt leads to more aggressive production choices In addition, the income of shareholders depend on the distribution of profits from the firm between debt and equity, so that decisions are affected by the financial structure and therefore by the firm leverage. This literature emphasizes the importance of limited liability associated with debt. A last remark leads to another dimension of the non-neutrality of finance; it is the role of credit. This may encourage managers to shareholders of firms increase the debt ratio to make riskier investments. [...]
[...] Thus, the new classical school and the proponents of the theory of neutrality to the Modigliani - Miller, does not arise since the funding of an economy has no real effect. The basic premise of this approach is that of complete markets. In all markets (goods, services or financial assets), prices have the same meaning i.e. homogeneous; they summarize all available information and the coordination mode is necessary and sufficiently decentralized to decisions. The theorem of Modigliani - Miller constitutes a serious obstacle to the analysis of the interaction between financial variables and cyclical fluctuations and many studies therefore discussed of the validity of this theorem. [...]
[...] In case of failure and bankruptcy, with limited liability, the majority of losses are borne by creditors. Because of these asymmetries and the perverse incentives that result, creditors will react by risk premiums and collateral. It follows that external finance is more expensive than internal finance. This mechanism breaks the equivalence between the various sources of funds. The Modigliani-Miller theorem can be applied. Also, these alternative sources of funding, such as the use of securities market or the call to the banking system cannot be substituted as shown by B. Greenwald, J. Stiglitz, A. [...]
[...] the criterion of a rational decision is to maximize the market value of the firm. the concept of cost of capital refers to the total cost, measured as the expected rate of return on investment in shares of comparable companies. all based on positive expectations (demand, profit . In the 1980s, we extended this analysis to all financial choices. Whatever the proportions in which households hold bank deposits, bonds or shares, the macroeconomic equilibrium is not affected if markets are complete (there is a market for each good or service now, but also future). [...]
[...] Second Theorem The value of a business is not affected by its dividend policy. Thus, an increase in dividends will increase shareholders' income, but will be offset by a decrease in the value of the title. The message is that we cannot further increase the value of a firm by affecting the distribution of its benefits for e.g. increase the weight of a cake by cutting it into slices of different sizes. Third Theorem In the presence of income taxes, the value of a levered firm is equal to the value of a firm without debt, plus the tax savings is due to debt. [...]
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