Chapter 16, Problem 1CQ

MM Assumptions List the three assumptions that lie behind the Modigliani-Miller theory in a world without taxes. Are these assumptions reasonable in the real world? Explain.

Summary Introduction

To determine: The three assumptions that come under the Modigiliani-Miller theory in a world without taxes.

Introduction:

Modigliani-Miller theory:

Professors Modigliani and Miller made a research on capital structure theory very intensely. From the analysis, it is found that they formed a capital structure irrelevance proposition.

Explanation of Solution

The three assumptions that come under the Modigiliani-Miller theory in a world without taxes:

1) People can obtain capital at the similar interest at which the firms are able to obtain. As investors can buy securities on a marginal rate, person’s efficient interest rate is most likely no greater than that for a company. Hence, this supposition is sensible when it is applicable for Modigiliani-Miller’s theory to the real world. If a company have the ability to obtain at a rate smaller than persons, the firm’s worth would rise through some leverage for corporates. As Modigiliani-Miller Proposition I illustrated, this is not applicable in a universe with no taxes.

2) When there is a no tax option. In the real universe, companies will pay taxes. In there is occurrence of corporate taxes, the company’s worth is positively associated to its level of debts. As the payment of interest is deductible, rising debts minimizes taxes and increases the company’s value.

3) There are no expenses of fiscal suffering. In the real world, the expenditure of monetary distress can be extensive. As shareholders ultimately tolerate these expenses, there is incentive for the firms to reduce the debt rate in its capital structure.