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The Capital Structure of the Organisation Maximize Firm Value and Minimize Average Cost of Funding

The Modigliani-Miller theorem is a significant arena of contemporary corporate finance. At its centre, the theory refers to an irrelevance proposition. The Modigliani Miller theory offers cases under which the financial decision of a firm does not have an effect on its value. According to the theorem, with well-functioning markets … and rational investors, who can ‘undo’ the corporate financial structure by holding positive or negative amounts of debt, the market value of the firm – debt plus equity – depends only on the income stream generated by its assets (Villamil, n.d., p.1). As per Modigliani, the firm value should not be dependent on the portion of debt within the financial structure. The Modigliani Miller theorem is comprised of four separate results which are fetched from a series of research papers. According to the first proposition, under some specific conditions, the debt-equity ratio of the firm would not have an impact on the market value. Among them, the first two are related to the firm’s capital structure. Miller has given an example for a better understanding of the theorem. For an instance, one can think that the firm is a huge tub of milk. The whole milk can be sold as it is. On the other hand, the cream can be separated out of the milk and can be sold at a significantly higher price than that of the whole milk. In this case, if there is no separation cost involved in this, as per the theorem, both the skim milk and cream together would have the same price as that of whole milk.

The Capital Structure of the Organisation Maximize Firm Value and Minimize Average Cost of Funding