MODIGLIANI AND MILLERS ADVICE ON DEBTS IGNORED BY COMPANIES Essay - 1

MODIGLIANI AND MILLERS ADVICE ON DEBTS IGNORED BY COMPANIES - Essay Example Considering the setting of a perfect market, with the absence of frictions, a seminal research conducted by Modigliani and Miller in 1958 proposed that the value of an organization’s market tends to operate in independence of such an organization’s capital structure. The argument by Modigliani and Miller had the essence, adding on the value of debt tends to lower the value of any outstanding capital (equity). Firm’s gain realized by utilizing more of the so seemed cheaper debt will be offset through the implementation of a higher costing policy of the adopted riskier equity. Therefore, considering a fixed value of total equity, the capital allocation between equity and debt will thus be irrelevant since the two capital costs’ weighted average will be of the same amount regardless of any possible combination of the two capital costs2. Unfortunately, no corporation operates in a perfect business world; few if any, are debt financed 100%. Since the realizatio n of the winning paper by Modigliani and Miller, a number of potential explanations regarding the applicability of certain financial structures have emerged, revolving around a number of elements such as the role of taxes, the default cost, credit rationing, equity dilution, and agency costs, while including goals by sponsors and management, yet such goals tend to differ from each other. Another suggestion by Modigliani and Miller is that organizations maintain a capacity of a borrowing reserve in order to accommodate instances of economic uncertainty. It is, therefore, essential to investigate each of the potential inefficiencies mentioned in the prior discussion. Regarding the impact of Taxes, Modigliani and Miller present assumptions which portray obvious violations on the deductibility of payments of interest, and tax as well as corporate taxes. Often, payments on interest committed to debtholders are part of the deductions exercised from corporate revenues before the taxation o f such revenues. Consequently, the retained corporate tax plays the role of a subsidy upon interest payments. On the other hand, if the income paid out is in the form of a dividend to stockholders, such an income will undergo double taxation. The initial taxation happens at the level of corporate through corporate taxes, while the subsequent taxation will be exerted on income tax upon holders of equity. Therefore, a corporation striving to reduce taxes while intending to maximize the incomes available to respective investors should, therefore, supports itself financially, entirely through debt3. Default Costs refer to costs associated with distresses of finances, and, more certainly, bankruptcy. Default costs help in keeping the firm from giving large amounts of debt in comparison to the firm’s amount of underlying financing equity. There are two forms of default costs; can either be implicit or explicit. Explicit default costs cover the payments committed to accountants, law yers, as well as other professionals who advise the firm in instances of liquidation and bankruptcy, or while filling protection forms. Explicit costs can portray an essential fraction of total assets of the corporation. Such fractions are committed to investors during bankruptcy. Additionally, it is essential for corporations to take into consideration, the indirect costs associated with the financial distress incurred when a firm approaches bankruptcy or even