Choices for Capital Structure for Firms Undergoing Merger Essay

Choices for Capital Structure for Firms Undergoing Merger - Essay Example The essay "Choices for Capital Structure for Firms Undergoing Merger" discusses the importance given to the propositions made by Modigliani and Miller when there are instances, such as mergers and acquisitions between two companies, which require raising new capital or reshuffling the existing capital structure. The understanding of the propositions presented by Modigliani and Miller reveals that there are four different outcomes which resulted from continuous research conducted in the late 50s and early 60s. At the beginning, Modigliani and Miller presented the first proposition which established that in the presence of certain conditions the choice of the capital structure of a firm, which comprises of proportions of debt and equity, does not have any impact on the overall value of that firm. The next proposition, which is the second one, puts forward the idea that the extent to which a firm leverages its business does not affect the WACC (weighted average cost of capital) of that firm. In other words, this idea proposed that the cost of capital, i.e. the equity based capital, is directly related to a linear function to the capital structure of the firm, i.e. the debt to equity ratio. The third theorem or proposition established that whatever may be the dividend policy of a firm, the market value is not affected by it. Lastly, the fourth proposition holds that the shareholders of a firm are not interested in the financial policies of their firm. Therefore, think of the firm as a gigantic tub of whole milk... The understanding of the propositions presented by Modigliani and Miller (1958) reveals that there are four different outcomes which resulted from continuous research conducted in late 50s and early 60s (Modigliani and Miller 1958, Modigliani and Miller 1963). At the beginning, Modigliani and Miller (1958) presented the first proposition which established that in the presence of certain conditions the choice of the capital structure of a firm, which comprises of proportions of debt and equity, does not have any impact on the overall value of that firm (Villamil 2006, Modigliani and Miller 1958). The next proposition, which is the second one, puts forward the idea that the extent to which a firm leverages its business does not affect the WACC (weighted average cost of capital) of that firm. In other words, this idea proposed that the cost of capital, i.e. the equity based capital, is directly related in a linear function to the capital structure of the firm, i.e. the debt to equity ra tio. The third theorem or proposition established that whatever may be the dividend policy of a firm, the market value is not affected by it. Lastly, the fourth proposition holds that the shareholders of a firm are not interested in the financial policies of their firm (Villamil 2006, Modigliani and Miller 1958). In order to explain the concepts underlying the propositions, Miller (1991) presented a simple example for the purpose of explaining the same. As per Miller (1991), â€Å"Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as it is. Or he can separate out the cream, and sell it at a considerably higher price than the