Share
Explore BrainMass

Trade Off Theory

"Optimal leverage refers to the amount of debt in a firm's capital structure, which minimizes the firm's cost of capital and thus maximizes its market value".

Please read the attached documents and discuss the above statement by illustrating how the optimal mix of debt and equity in capital structure is attained where there is a trade-off between the expected benefits and costs of debt financing.

Do NOT references/quote anything from the attached documents, please use other external sources.
And please use Harvard referencing.

Attachments

Solution Preview

"Optimal leverage refers to the amount of debt in a firm's capital structure, which minimizes the firm's cost of capital and thus maximizes its market value"
The optimal leverage is one that maximizes the value of the firm and at the same time minimizes the firm's cost of capital. Now, we first need to establish the relationship between the amount of debt in the firm's capital structure and the market value. Now according to Modigliani & Miller first proposition, the value of the firm does not depend on its capital structure. They have asserted that if there are two firms that have the same business operations and the same kind of assets the value of the firm does not depend on its capital structure. If the only thing that is different among the two firms is its liabilities then how they finance their business activities is irrelevant. In short, how debt and equity is structured is irrelevant. According to Modigliani & Miller the value of the firm is determined by its real assets and not its capital structure. This assertion is however based on assumptions that there are no taxes, asymmetrical information, and bankruptcy costs. In addition, it is assumed that the markets are efficient. These assumptions are unrealistic (Nikolaos Eriotis, Dimitrios Vasiliou, Zoe Ventoura-Neokosmidi, 2007).
Modigliani & Miller came up with proposition II that says that the value of the firm depends on the required rate of return on firm's assets, cost of debt of the firm, and the debt equity ratio of the firm.

The assertion of Modigliani & Miller is important because it says that increase in expected return due to financial leverage is sufficient to compensate the shareholders for the increase in risk. If the assumptions of proposition I hold the increase in return to stock-holders resulting from the use of leverage is cancelled out by the increase in ...

Solution Summary

This answer provides you an excellent discussion on Trade Off Theory

$2.19