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3. What is the Optimal Capital Structure?

RR
von Reinhold R.

What does the The Modigliani-Miller Theorem say

  • under perfect market conditions, the market value of a company cannot be increased by altering the claims on its assets, i.e., by changing its debt-equity ratio. -> A company’s capital structure is therefore irrelevant

  • starting point of the modern thinking on capital theory

assumptions:

  • An investment policy is taken as given.

  • Investors demand a certain average gross return on their investment. Although questionable in practice, this model assumes that all investors have the same expectations for their investment.

  • Companies can be divided into homogeneous risk classes. Within these risk classes, the risk of possible fluctuations in gains over time is the same.

  • Allocating a company to a certain risk class permits a comparison with the known market values of other companies in the same risk class. Business risk and debt risk can be assessed individually for their impact on market value.

  • A perfect efficient capital market exists. For any two companies in the same risk class that do not carry debts, their average cost of capital will be the same, and the price per share of expected profits as well as the company value are the same. There are no capital market restrictions. All participants have equal access to the capital market. Financing instruments are freely available to all. Financing instruments are infinitely divisible. There are no information or transaction costs.

  • Equity investors have expectations in terms of their effective returns. Due to the formation of risk classes, differences in the valuation of companies can be attributed exclusively to different business risks.

  • Borrowing costs are independent of the debt-equity ratio, whereby shareholders can take on debt at the same rates as companies.

  • The interest rate on capital investments and borrowing is uniform. • Companies either can finance their operations through risk-free debt capital or via equity capital that is exposed to risk.

  • Cash flows are assumed to continue in perpetuity.


Author

Reinhold R.

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