Problem Speech or Presentation Example | Topics and Well Written Essays - 500 words

Problem - Speech or Presentation Example Financial position to increase by less than half: Of course, the recommendation assumes that the stock split will not have effect on the price, but it does have an effect because the price is a factor of the demand and supply in the market. And while perfect information is assumed under Modigliani and Miller argument, the price is supposed to drop. Although this drop in market price cannot be estimated fully as to how much, the increase in financial position with at least the amount of stock that is traded, by undertaking this decision on capital structure, the financial position will increase at least by less than half. Modigliani and Miller proposes that debt policy should not matter, as in a tax-free economy and well-functioning markets, dividing the capital structure between debt and equity will have no effect on the total value of the company. But in the real world where taxes are prevalent, taxes provide tax shield or tax deductions for interest expenses. This gives a firm advantages of utilizing debt for its capital structure. The effect of increasing debt results in what has been called financial leverage. This is apparent in the computation of cost of capital; by computing the relative weights of debt and equity as proportions to the overall capital mix, multiplied by their returns cost of capital is computed. However, the computation is not complete unless the tax deductions for interest expenses, hence the tax rate is subtracted from the return of debt, which is then multiplied to the proportion of debt in the capital structure. Given this, increase in debt, as it gives tax advantages, lowers the cost of capital for the firm. Because of this implication, it seems to be beneficial for financial managers to increase debt in order to decrease the cost of capital for the firm. The cost of capital for the firm has a serious implication