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Modigliani And Miller Essay

921 words - 4 pages

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 ...view middle of the document...

The extrapolation of the profit maximization criterion of the certainty model has evolved into utility maximization (Utiliy Approach). The utility approach gives some meaning to the cost of different types of funds. But this approach has its own drawbacks, like the subjective concept of cost of capital.
Finally, we reach a third approach (Alterative Approach or Market Value Approach) that provides a useful source to the understanding of cost of capital and a workable theory of investment. This approach has many potential advantages, but there is a lack of an adequate theory of the effect of financial structure on market valuations. The goal of the paper is to develop such theory and its implications for the cost of capital problem.

The Modigliani and Miller theorem can be used to answer the cost of capital question and permits us to develop a theory of investment of the firm under conditions of uncertainty. It is a partial-equilibrium approach focusing on the firm and industry, because it is at this level that the interests of the various specialists concerned with the cost of capital problem come most closely together. The prices of certain income streams will be treated as constant and given form outside the model. The results obtained in this paper provides the essential building blocks for a general equilibrium model which will show how these prices that are taken as given, are themselves determined.

Modigliani and Miller theorem is a cornerstone of modern corporate finance using the market value maximization approach. The aim of the theorem is to provide different conditions under which a firm´s financial decision do not affect its value. Modigliani and Miller state that in a situation where there are perfect markets, rational investors and...

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