Discussion post and response
Learning Goal: I’m working on a business discussion question and need a sample draft to help me learn.
Part 1 It should be at least 500 words within text citations. Use at least 2 references that are websites and based in the United States.
Graham, Harvey, and Puri (2015) conducted a survey on how financial executives (i.e., 1,000 CEOs and CFOs) around the world make decisions about capital allocation and how they delegate capital to particular projects. They find that over nearly 79% of CEOs make investment decisions based on a project’s NPV and about 66% state that cash flow timing is an important consideration that they evaluate when making capital allocation decisions. These findings pair nicely with the material that we are covering this week, which include understanding valuation techniques such as the calculation of the Net Present Value (NPV), Internal Rate of Return (IRR), Payback, and Profitability Index for a particular project. However, the results of the survey also indicate that managerial reputation and rank of the person that is responsible for the project are also important considerations that CEOs and CFOs take into consideration when making capital allocation decisions.
The questions that you should consider when responding to this week’s discussion board are as follows: The capital budgeting process is important, but is it the most important process that a firm undertakes. Why or why not? If you believe there is a more important process, what is it and why do you think it is more important?
- For a visual representation see Fig 1 of page 463 in the recommended reading.
- Graham, J., Harvey, C., and Puri, M. (2015). Capital allocation and delegation of decision-making authority within firms. Journal of Financial Economics, 115, 449-470.
Part 2(A) Should be at least 300 words with in text citations and at least 2 references that are based in the United States and websites.
According to Modigliani and Miller, because of the perfect market, the value of a firm should not have any effects on its capital structure. They figured that a firm’s cash flow remains equal to the cash flow of the project it undertakes, and thus they should have the same present value. Modigliani and Miller come up with two theoretical propositions, I and II. In the Modigliani-Miller proportions, I advocate that the market value of any firm is derived irrespective of the capital structure, and any change in the equity capital or maybe the debt capital will not lead to any additional creation value. The MM Proposition II states that the percentage of the debt in the capital structure increases the cost of equity of the firm (Berk & DeMarzo, 2019).
The Modigliani-Miller theory effectively goes back to the La of One, where everyone gets information about the market that is ready and accurate in a perfectly efficient market. In this market, the firm does not pay tax, nor do they pay transaction costs (Miller, 1988). The theory also theorized about the form of paying taxes and transaction costs. The key feature of the MM Propositions is that they give a firm the best way to calculate options for raising money for future use in its operations and projects (Bhattacharya, 1988). Because there are perfects and efficient markets, a firm can compare multiple companies and do benchmarking for their performance (Leveraged with debt and unleveraged without debt), the values, the prices of stock, and the outstanding share to have the best option of raising money. It is relative to different factors that keep all things equal.
Modigliani and Miller’s Proposition are not genuine since capital markets are not perfect in the real world. That is why they fail when put into practice because the firm cannot get away totally from the limitations the MM theory states. For instance, if we have two firms that trade at different total prices, the law does not hold, and an arbitrage opportunity exists. Therefore, in this scenario, arbitrage can exploit the price differences in their favor.
Berk, J. B., & DeMarzo, P. M. (2019). Corporate finance. Pearson.
Bhattacharya, S. (1988). Corporate Finance and the Legacy of Miller and Modigliani. Journal of Economic Perspectives, 2(4), 135–147. https://doi.org/10.1257/jep.2.4.135
Miller, M. H. (1988). The Modigliani-Miller Propositions After Thirty Years. Journal of Economic Perspectives, 2(4), 99–120. https://doi.org/10.1257/jep.2.4.99.
Part 2(B) Should be at least 300 words with in text citations and at least 2 references that are based in the United States and websites.
The Modigliani-Miller I Proposition says that the market value of a company is correct when it is calculated as the present value of its future earnings, and its underlying assets. Theoretically this means that it does not matter how a company chooses to finance its growth; for example, deciding between borrowing money, issuing new stocks or reinvesting profits (Chen, 2022). The capital structure a company chooses does not affect the value of the company, whether it is 0% debt and 100% equity, or whether it is 20% debt and 80% equity.
The Modigliani-Miller II Proposition states that the cost of capital of leveraged equity will increase with the firm’s market value debt-equity ratio. This is because an increase in leverage level leads to a higher default possibility for the company. Investors want to be compensated for the additional risk they are taking for investing in the company (M&M theorem 2022).
One limitation to these propositions is that they rely on the assumption that it is a perfect capital market. In reality though, the market has some imperfections which can cause a deviation to the theory. Some imperfections that affect the propositions are taxes, transaction costs and issuance costs. None of which would exist in a perfect market (Berk & DeMarzo, 2020).
Berk, J., & DeMarzo, P. (2020). Summary: Capital Structure in a Perfect Market. In Corporate finance (5th ed., pp. 517–517). essay, Pearson Education Limited.
Chen, J. (2022, July 8). What is the modigliani-miller theorem (M&M)? Investopedia. Retrieved August 4, 2022, from https://www.investopedia.com/terms/m/modigliani-mi…
M&M theorem. Corporate Finance Institute. (2022, January 31). Retrieved August 4, 2022, from https://corporatefinanceinstitute.com/resources/knowledge/finance/mm-theorem/#:~:text=The%20second%20proposition%20of%20the,default%20probability%20to%20a%20company.