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M& M theory N1 ( perfect capital market with no taxation)
there is a linear relationship between cost of equity and financial risk. ( as opposed to the traditional view)
There is no optimal structure because as a company gears up the cost of equity increased at a rate that exactly cancelled out the reduction effect of cheaper debt. In conclusion the WACC is constant !
Theory N2 ( with tax)
They managed to prove that as gearing goes up the wacc steadily goes down . Companies should choose a 99.9 % gearing level.Yeah I don’t know why researchers spend so much time on theories that don’t relate to the real world. M&M came up with this marvelous concept on financial management. They said that shareholder wealth is only affected by the investment decision and not the dividend or financing decision under the condition that capital markets were perfect. As Barbara pointed out above the financial decision to use debt or equity is not important. Likewise the dividend irrelevant theory states that paying a dividend or not does’t effect shareholder wealth assuming that there is full information.
But we don’t live in perfect capital markets; we don’t have freedom of information and we do pay tax. Hence M&M quickly carried out another study this time using tax. But this is still flawed as companies don’t gear up like headless chickens as Insolvency risk and finance pressures quite rightly have a say in this.
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