Fin 4610

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Debt is Good for You (01/25/2001)

Franco Modigliani and Merton Miller published their famous theory about the optimal balance on debt and equity of the corporate finance. In the Modigliani –Miller theory they stated that the value of the firm is independent of firm’s capital structure. As the portion of debt goes up, the firm will be riskier, and the expected return will increase. In an efficient market, the business risk does not vary with leverage. But later, Modigliani –Miller theory modified that taxation should be taken into account. The tax rate on dividend paid out is heavier than tax rate on debt because the interest paid on debt is deductible which means the value of a firm will increase by taking more debt financing. Modigliani and Miller implied that firms should be financed almost entirely with debt. However, many firms still think that the costs on mix of debt and equity and risks are lower if they want to maintain certain credit rating. The firms may worried on borrowing too much debt will lead to bankruptcy. Inflation is also a risk on debt financing because of the interest paid out. The article indicated that there are two theories explained the reason why firms do not want to borrow that much. The first one is trade-off theory, which stated that the portion of debt a firm takes should depend on its operational performance. The companies with better performance can afford more debt. However, there are some arguments on this theory, an analyst from J.P. Morgan stated that only very few profitable companies borrow more when they have good performances. Firms are more interest in business plans rather than credit rating. Issuing equity may affect outside investors’ view on the firm and external finance is costly. The pecking-order theory explained why many big firms hold large cash reserve. Financing comes from three sources, internal funds, debt and new equity. Companies prioritize their sources of financing, first preferring internal...
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