Financial Management Miller and Modigliani

Question: Discuss about theFinancial Managementfor Miller and Modigliani. Answer: Introduction Miller and Modigliani (MM), two professors studied the theories related to capital structure in-depth. As per their evaluation, they were developed the irrelevance proposition for capital-structure. Most importantly, it was hypothesized by them that in the perfect market conditions, the capital structure does not have a role in the operations of finance. They stated that the firms market value is concluded by the risks associated with its underlying assets and the earning power. It further stated that the value of the firm is independent and it has the option to select the finances for the purpose its investment or to distribute the dividends (Cvijanovi? 2014). The MM approach is primarily based on the below mentioned assumptions: No cost for bankruptcy No cost for transaction No taxes No impact of debt on the earnings of the company before payment of taxes and interest Investors and companies have same information regarding the market condition Borrowing costs are same for the investors as well as the companies However, in the real world all the above mentioned costs exist. This report will illustrate the fact that the choices of capital structure have great impact on the real investment policy of the company (Saunders and Cornett 2014). Discussion The decisions related to the capital structure have an impact on the financial related risks and therefore, it affects the value of the organization. The theories related to the capital structure assists to understand the most crucial facts related to the relationship among the value of the organization and the structure of the capital (Rampini and Viswanathan 2013). The development of the capital structure theory starts with the Modigliani and Millers capital structure theory. While taking the decisions, various factors like cost of agency, costs related to financial distress, costs related to asymmetric information, deduction of interest, benefits related to tax and irrelevancy of capital structure are taken into consideration. Modigliani and miller implemented a theory that assisted to understand how the financial distress and the taxes impact the capital structure decision of the company (Muathe, Mwangi and Kosimbei 2014). However, the assumptions of the model are not realistic b ut they assist to work through the impacts of the decision related to capital structure that: The investors have the standardized expectations for the future cash flows Stocks and bonds are traded in the perfect markets Investors have the option to lend and borrow at the same rate No agency costs are involved in the investment The financing and investment decisions are independent of each other (Cummins and Weiss 2016). Based on the hypothesis that there are no agency costs, no taxes, no financial distress, therefore, the investors will perform the valuation with the same rate of cash flows irrespective of how the organizations are financed. The reason behind that is there are no advantages for borrowing at the firm level as there is no deduction for the interest. Firms will be indifferent with regard to the capital sources and the investors can make the usage for the financial leverage, if they wish so (Khan, Ahsan and Malik 2016). The cost of the financial distress is the costs that are related with the firm while facing difficulty in achieving their target. These costs include the opportunity cost for not taking any optimal decisions, not able to negotiate any long-term supply contracts and the fear of customer loss. The cost of financial distress goes up with the increase of dent financing, which in turn, reduce the worth of the firm. Further, the expected distress cost has an impact on the equity and debt. Therefore, it can be stated that there is an optimal level of capital structure at which the firm value is maximized and the capital structure cost is minimized. On the other hand, the agency costs are associated with the segregation of management and the owners. An agency cost includes the residual loss, monitoring cost and bonding cost (Doidge and Dyck 2015). The agency cost will be reduced if the company has better corporate governance. The agency cost increase the equity cost and decrease the worth of the firm. The higher the debt ratio of the firm, the lower the monitoring cost as well as the equity cost. On the contrary, the agency cost associated with debt reduces the bankruptcy cost and the proportion of growth option for the value of the firm and will increase the rate of corporate tax and instability of the cash flows (Wajid and Shah 2017). Conclusion It is concluded from the above discussion that there is a correlation among the capital structure and the investment decision while the equity holders select the policy of growth option and the decisions related to the debt structure are affected by the investment benefits, interest tax shields, agency costs, bankruptcy cost and security insurance cost. The structure for debt preference has great impact on mitigating the conflicts of the shareholders over the investment policies. Further, the agency conflicts regarding the financing and timing for future investment can have estimated regarding the level of optimal leverage to select the optimal investment policy. The firms with higher financial distress and higher risks are tending to choose the high proportion of subordinate debt for their debt structure. Further, the firms that are having less opportunities for growth, they prefer senior debt whereas, the firms with financial constraint without or with the opportunities of growth, prefer the junior debt. Various other outcomes also have impact on the capital structure and the investment policy. Further, as per the theory of Miller and Modigliani, the financial leverage is in the direct proportion with the cost of equity. With the increase of debt element, the equity stakeholders assume higher risk for the organization. Therefore, in turn, the stakeholders expect higher return and therefore the equity cost goes up. This states that, higher the cost or proportion of debt, lower the weighted average cost of capital. This above stated theory of Miller and Modigliani is one of the modern strategies for the theory of capital structure. Reference Cummins, J.D. and Weiss, M.A., 2016. Equity Capital, Internal Capital Markets, and Optimal Capital Structure in the US Property-Casualty Insurance Industry.Annual Review of Financial Economics,8, pp.121-153. Cvijanovi?, D., 2014. Real estate prices and firm capital structure.Review of Financial Studies,27(9), pp.2690-2735. Doidge, C. and Dyck, A., 2015. Taxes and corporate policies: Evidence from a quasi natural experiment.The Journal of Finance,70(1), pp.45-89. Khan, J.S., Ahsan, S.M. and Malik, H.A., 2016. Impact of Ownership Structure on Dividend Policy and Capital Structure: Evidence from Non-Financial Sector of Pakistan. Muathe, S.M.A., Mwangi, L.W. and Kosimbei, G.K., 2014. Relationship between capital structure and performance of non-financial companies listed in the Nairobi Securities Exchange, Kenya. Rampini, A.A. and Viswanathan, S., 2013. Collateral and capital structure.Journal of Financial Economics,109(2), pp.466-492. Saunders, A. and Cornett, M.M., 2014.Financial institutions management. McGraw-Hill Education,. Wajid, H. and Shah, S.A., 2017. The Influence of Corporate Governance and Ownership Structure on Capital Structure of Pakistani Listed Companies.Journal of Contemporary Management Sciences,1(2), pp.31-46.