Firms around the world rise funds in the capital markets to finance their expansion, acquisitions and other operations. This is usually done through equity and/or debt financing. Equity financing is the process in which a firm raises capital through the sale of shares. Debt financing involves the firm borrowing through, for example by issuing bonds.
The firm‘s decision on how to rise capital influences its capital structure and as a result may affect the value of the firm. It is therefore important that the firm must take into account the risks involved in both equity and debt financing. In order to be able to make an optimal decision, a firm that uses the combination of both equity and debt ...view middle of the document...
e. at a risk free interest rate;
• There are no taxes; and
• There are no bankruptcy costs
According to Modigliani and Miller, the value of the firm is determined by the net operating income earned on its physical assets or its cash flow. The value of leveraged firm is the same as the value of unleveraged firm, i.e. the value of the firm with debt is the same with the value of the firm without debt.
Modigliani and Miller‘s argument does not hold in the real world where financial decisions of the firm are influenced by a variety of factors. For example, in a real world, tax plays a critical role in the financing decision of the firm which is in contrast with Modigliani and Miller assumption that there is no tax. This includes corporate tax and personal income tax.
Taking corporate tax into account, it can be concluded that the debt-equity ratio affects the value of the firm and therefore is relevant. Corporate tax affects the net operating income of the firm and therefore the value of the firm. In this regard the decision of the firm‘s capital structure must be such that the effect of corporate tax on the value of the firm is minimized.
In a firm with all equity capital structure, corporate tax reduces the value of the firm more than the leveraged firm or firm with debt. Corporate tax can create a tax shield if the firm is partly financed by debt.
Company X will pay less tax if it replaces 50 percent equity with debt than if it remains all equity company. This is because the government or tax authorities treat the interest differently from the way the treat earnings to shareholders. Interest is able to avoid tax while earnings after interest but before corporate taxes are taxed at the corporate rate. Therefore, based on the information provided for company X, the increase in the debt- equity ratio will increase the value of the company:
All equity firm Firm with 50% debt
Earning before tax £1 million £1 million
Interest 0 £30 000 @ 3%
Pretax income £1 million £970 000
Tax @30% £300 000 £291 000
Net cash flow £700 000 £679 000
Tax shield gives the firm with high amount of debt, a higher market value than the one with a lower level of debt. The total value of the firm is calculated as follows:
Firm value = Value of all equity firm +tax shield
= £700 000 + £30 000
= £730 000
Because the firm deduct interest payments on debt as an expense and dividend payment to shareholders are not tax deductible. Debt has a benefit to firm. The value of the firm increases by raising the debt-equity ratio if the present value of the corporate tax shield is greater than the extra cost of marginal investor would have to bear in the form increases tax.
Modigliani and Miller also argued that the firm‘s capital structure does not affect the cost of capital and therefore the change in debt-equity ratio does not affect the cost of the firm. As the debt-equity ratio increases, the expected return on equity increase, expected return on debt does not...