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What is the difference between traditional and modigiliani and miller’s theory regarding capital structure.
The traditional view is that the weighted average cost of capital (and therefore the total market value of the company) will change with changes in the capital structure. Therefore their must be an optimal capital structure where WACC is at a minimum and total market value is at a maximum. However the traditional view does not attempt to predict where that optimal level is.
M&M came up with formulae for how things will change with capital structure (having made various assumptions) and found that in the absence of tax the WACC and total MV would stay constant. With tax they found that WACC will fall (and MV increase) with higher level of gearing, but in a very predictable way (the came up with formulae for how they would change).
I think traditional view and static trade off theory are ok – at beginning there is tax shield for Kd, then later there is financial distress, therefore there is a optimal WACC. But why M&M theory says there is no optimal WACC, pls?
I have already answered this in my answer above.
When ignoring tax, they proved that the WACC stays constant. If it stays constant then there cannot be an optimal level of gearing.
With tax, they proved that the WACC falls with higher gearing and therefore the company should raise as much debt as possible – therefore there is an optimal level of gearing.
You will remember from F9 the assumptions that they made in their proof – one big one being that they ignore the risk of bankruptcy (which is a big problem obviously in real life).
(Incidentally the traditional theory does not rely on there being tax relief on debt at all – the same logic applies with or without tax relief.)
Have you watched my lecture on this?
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