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Modigliani and Miller

In: Business and Management

Submitted By teregalnares
Words 921
Pages 4
This paper provides a theory on the effect of financial structure of the firm on market valuations. In other words, does capital structure influence value of the firm?
I believe the introduction of the paper gives an important explanation of how Modigliani has reached his theorem, because his main goal was to correct the drawbacks of other theories. To understand the importance of such a theory, I considered adding these other theories as an introduction of this summary.
The cost of capital to the owners of a firm is simply the rate of interest in bonds; this has derived the proposition that the firm, acting rationally, will tend to push investment to the point where the marginal yield on physical assets is equal to the market rate of interest. This proposition follows from either of two criteria of rational decision-making: (1) the maximization of profits, and (2) the maximization of market value. Under either formulation, the cost of capital is equal to the rate of interest on bonds. These have equivalent implications under certainty (Certainty Equivalent Approach) but not under uncertainty. The attempt of allowing uncertainty takes the form of superimposing on the results of the certainty analysis the notion of a risk discount to be subtracted from the expected yield. No satisfactory explanation has yet been provided as to what determines the size of the risk discount and how it varies in response to changes in other variables. The profit maximization criterion, under the world of uncertainty, is no longer well defined; there corresponds to each decision of the firm not a unique profit outcome, but a plurality of mutually exclusive outcomes which can at best be described by a subjective probability function. Profit outcome has become a random variable and its maximization has no longer an operational meaning. Why? Because to compare profit outcomes of…...

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