Discussion of the theories on Optimal Capital Structure Essay

Discussion of the theories on Optimal detonating device Structure - Essay ExampleThe study by Modigliani and Miller was based on the following surmises1. in that respect are no brokerage costs.2.There are no taxes.3.There are no unsuccessful person costs.4.Investors can borrow at the same rate as corporations.5.All investors have the same cultivation as management about the incorruptibles future investment opportunities.6.EBIT is not affected by the use of debt.This theory says that if these assumptions hold true, the value of the firm is not affected by the great expression. This function is expressed as followsVL = VU = SL + D.Here VL is the value of a levered firm, VU is the value of an identical, unlevered firm, SL is the value of the levered firms business line and D is the value of its debt.As we know that WACC is a combination of cost of debt and cost of rectitude. The cost of debt is reject than the cost of lawfulness. As a company raises capital through debt, the weight of debt enlarges and hence, it drives up the cost of equity as equity gets riskier. According to the assumptions by Modigliani and Miller, the cost of equity increases by an heart to keep the WACC constant. In other words, under these assumptions it does not matter whether the firm uses debt or equity to raise capital. So, capital structure decisions are irrelevant in such conditions. Modigliani and Miller The erect of Corporate Taxes In 1963, Modigliani and Miller relaxed the assumption that there are no corporate taxes. The corporate tax laws favour debt financing over equity financing because the tax laws allow companies to deduct interest payments as expense and on the other feed dividends are not deductible. So this treatment encourages debt financing. Interest payments reduce the amount the firm pays to the government in the form of taxes and more of its cash is available for its investors. Hence, tax deductibility of the interest payments acts as a shield for the firms income before tax. Modigliani and Miller presented this concept as follows VL = VU + Value of side effects = VU + PV of tax shield. They come along simplified the concept as VL = VU + TD. Here T is the corporate tax rate and D is the amount of debt. This relationship is expressed in the graph below. If the corporate tax rate is 40%, then this linguistic rule implies that every dollar of debt will increase the value of the firm by 40 cents. Hence, the optimal capital structure is 100% debt. Under this theory, the cost of equity increases as the amount of debt increases but it does not increase as fast as it does under the assumption that there are no taxes. As a result, under this theory the WACC falls as the amount of debt increases. This relationship is shown in the following graph. Miller The Effect of corporate and personal taxes Later Miller brought in the aspect of personal taxes in this model. He tell that income from the bonds is considered as interest which is taxe d as personal income at a particular rate (Td). On the other hand, income from credit lines comes in the form of dividends and capital pretends. The tax on long-term capital gains is deferred until the stock is sold and the gain is realized. Of the stock is held until the owner dies no capital gains tax is paid. So he concluded that the returns on stock are taxed at a lower effective tax rate (Ts) than returns on debt. Looking gat this, Miller argued