Corporate finance Assignment Example | Topics and Well Written Essays - 3000 words

Corporate finance - Assignment manakinMiller & Modigliani capital structure irrelevance proposition In the year 1958 Franco Modigliani and Merton Miller highlighted that in perfective aspect capital markets the capital structure does not have any influence on the value of the securely rendering it irrelevant. The perfect capital markets are not characterised by any market frictions like job costs, taxes and the information is easily transmitted between the investors and the managers. M&M made a clear character between the financial put on the line 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 away 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 th e firm. ... The firms as well as individuals can borrow or lend at the risk-free interest rate. The firms employ risky impartiality and risk-free debt. There exist only corporate taxes i.e. absence of personal income taxes or wealth taxes. They mistaken perpetuity of cash flows i.e. assuming the growth rate to be zero (Lee, et al., 2009, p.202). As per M&M model the value of levered firm (VL) is equal to the value of unlevered firm (VU). Suppose there are deuce companies- Company 1 and Company2. It is assumed that the deuce companies have identical cash flows and belong to same risk profile. The difference between the two companies is with respect to financing. M&M fix that the market value of the two companies is same. Suppose the pay-off of Company 1 in good state is one hundred sixty 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 combinatio n of debt and equity. Suppose the get debt of Company 2 is $60 and its market value is $50 the market value of its equity is $50. thus the value of the Company 2 is- VL = Value of its equity + Value of debt = 50+50 =100 instanter if the value of Company 1 is different from Company 2 say 103. Then an arbitrage strategy can be created- An investor can sell Company 1 at 103. He can procure the equity of Company 2 at $50 and debt at $50. The net cash flow is- = 103-100 =3 This process will continue until the Value of Company 1 is equal to Company 2 (Banal-Estanol , 2010). The annex in leverage component raises the risk and return of the shareholders. This can be stated as- RE = RO + (B/S)(RO RD) RE is the return on levered equity RO is return on unlevered equity B is the debt value S is the