1. Give a critical appraisal of the (a) traditional Approach and (b) the Modigliani-Miller Approach to the theory of capital structure. 2. Explain briefly the view of traditional writers on the...

1. Traditional approach to the theory of capital structure states that a company should have a capital structure that would minimize its weighted average cost of capital and maximizes the shareholders’ value. Thus, when the marginal cost of debt is equal to the marginal cost of equity, then an optimal capital structure is defined.
However, Modigliani-miller theory suggest that the capital structure is irrelevant when maximizing the value of a company. Thus, it means that whether the company has high amount of leverage or not, it won’t affect its overall value.
2. According to the traditional writers, it was believed that a company’s value increases to an extent when leverage is introduced in the capital structure. However, once a threshold is passed, the value of the firm stops increasing and eventually starts declining due to various other factors that affect the value, such as the cost of financial distress.
3. As per MM, there is no effect on the value of a firm when there is a change in its capital structure. This statement is stated in the capital structure irrelevance theory. However, if a company that is completely unlevered and wants to gain some leverage, then it may use homemade leverage wherein the shareholders lend to the company and make it a levered firm.
4. Some of the weaknesses of MM theory are:
a. The market is not perfect.
b. There are transaction costs in the real world
c. Flotation costs also affect value
d. There are uncertainties about future capital gains and the preference for dividends that are to be received now.
5.
a. If a company that is completely unlevered and wants to gain some leverage, then it may use homemade leverage wherein the shareholders lend to the company and make it a levered firm.
b. Arbitrage is the process wherein an asset is bought at a cheaper price in one market and sold at a higher price in another market.
c. NI approach states that there is no effect on the value of the firm due to a mix of debt and equity in the capital structure. NOI approach states that the capital structure decisions is completely irrelevant and the DFL of a firm does not affect its total cost of capital and the market value of the firm.
d. When the cost of funds of a company are higher than the sales proceeds from an investment, then it is said to be reverse leverage.
e. As per MM with taxes, a firm’s value with leverage is higher...