6.12 A firm shall not use its full debt capacity. A gap should be maintained for scope
to borrow money at any time. This will help the firm to borrow on favorable
terms. When the borrowing rate is low and when borrowing is essential, it is
better to go for debt financing because, at low cost of capital long term bonds can
be obtained. This will be controlled by the EBIT divided by the total interest
charges.
6.13 Major stock holders often attempt to takeover management from the existing
management group by way of purchasing the minimum required number shares.
Therefore, the existing management group must be careful about using equity
leverage. On the other hand, creditors may assume control, in case of default as
per debt agreement. All these factors will fix the management between the
financial layers to use the leverages to determine the capital structure.
6.14 Change in capital structure will influence the future profitability and in turn it will
have effect on other variables.
6.15 In practice, finance managers focus on identifying a level of debt, where they can
be comfortable with getting all the benefits of debt and to keep the financial risk
within these operational limits.
- The Modigliani-Miller Model
7.1 Initially MM model is based upon the assumption of zero corporate or personal
income taxes. In the absence of the taxes, the value of the firm is independent of
its leverage.
7.2 They argued that, it does not matter, whether the company finances its activities
by debt or by equity or with combination of both. The exemption of interest on
debt from corporate tax also does not matter. They stressed that companies
should finance their activities through debt or use their portion of profit to finance
their activities.
7.3 As the use of debt rises, correspondingly cost of equity also rises.
7.4 The capital structure has got no effect on the value of a firm and its weighted
average cost of capital (WACC)
7.5 With two company’s modules, MM theory established that companies may differ
from the point of how they are financed and their respective total market values
7.6 The investors may sell the shares of the higher valued firm and may resort to
purchase shares of the lower-valued firm. This transaction will go up to a point
where both the firms will have same market value. MM argues that
disequilibrium finally must end and cannot persist. All these arguments are based