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Modigliani and Miller

Essay by   •  January 11, 2012  •  Essay  •  761 Words (4 Pages)  •  1,379 Views

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Miles in his speech refers to M&M and their ideas.

All companies need to obtain funds to finance their assets.These funds can be obtained from a variety of sources.

A bank can obtain funds from depositors, loans from debtholders or shareholders.

These investors expect to earn a return on their money and the higher the risk they take the higher the return they expect.This return investors require becomes the cost of funds to the bank.

The return depends on the risk and this depends on the assets the bank has invested in.

If they have made loans to customers who may not be able to repay them then the investors face risk and will expect a return to compensate.

M&M argued that since this was the source of risk and hence the return expected and the cost of funds to the bank only a change in that level of risk would affect the cost of funds.

Altering the source of funding could not affect the risk or the overall return required.Changing the source of funding just altered who bore the risk.

Miles argues that the banks only need to swap some of their current debt finance for equity finance.This is just changing the source of funding and according to M&M will not alter the overall cost.

E.g IF we ignore deposit financing and assume a level of risk that requires an overall cost of funds of 6% we can see how changing the source can affect the risk and return of the individual components of debt and equity but not the overall

100% debt finance cost of debt6% overall cost 6%

90% debt 5%

10%equity 15% overall 6%

80% debt 4%

20% equity 14% overall 6%

50% debt 2%

50% equity 10% overall 6%

100% equity 6% overall 6%

The example shows that as you move from 90% debt to 80% debt with more equity to absorb losses debt finance becomes cheaper and with more equity to spread the losses over average cost of equity reduces but overall cost remains a 6%

Frictions.

Newtons theory of gravity ignores the effect of air resistence on a body as it falls to the ground.

In the same way M&M theory may ignore some real phenomena that may result in an overall increase in cost of

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