Modigliani, Miller and the Green Business Data

Introduction

Many studies have been carried out on the optimal capital structure that any company should have. Many of these studies have laid their emphasis on the type of debt and equity structure that a company has in its capital structure.The management of Small Green business are  faced by a complex decision on whether  to use equity, or debt in their capital structure. Many studies that have been carried out revolved on those factors that influences capital structure  decisions , they uses Modigliani-Miller as their expression of making choice between equity and debt.

The preposition that were made on optimum capital structure by Miller and Modigliani (M& M)  makes significant contributions in the development of theory on corporate finance. Before Miller and Modigliani developed their theory in 1958, the view that was commonly accepted was base on each company/ business had a unique capital structure. This optimal capital structure was mainly determined by the unique features that the firm/ business in question exhibited. Modigliani and Miller came up with a completely different view. Their theorems come up first in a seminar paper written in 1958, on corporate valuation, cost of various forms of capital and, finally, on capital structure. Modigliani and Miller in 1963 realised some short comings on their previuos observations and made the following corrections, corporate tax structure always gives some tax relief on the various debt interest payments, but this does not apply to corporate dividend payment. M & M in 1977 built an equilibrium, this shows representation of supply of various debts by all firms as they expand. The investors who are within high tax brackets are enticed  to hold firm debt, this is done by encouraging them to receive their incomes in forms of interest other than gains from the capital.The next part involves further analysis of the new delevelopment by M & M.

The basic irrelevance model of capital structure- The M & M model is based on the assumptions of the perfect market. This assumptions includes:

(i) Every participant in the market is believed to have perfect information.

(ii) Barriers do not exist on exit or entry in the market, like transaction costs.

(iii) No one can influence market prices individually, this means that every participant in the market is said to be a price taker.

(iv) There is only one interest rate for lending and borrowing.

(v) There are uniform products in the market.

(vi) Distortion firm/corporate, as well as personal taxes do not exist.

The capiat markets, which are perfect, should hold the principle of value additivity. This means that if the cash  inflow stream is sub divided into certain sets of component streams, the original stream present value should be equal to the sum of the present values of the sub divided component streams. M & M  made an assumption that debt  was a of risk free form/type and they further believed that all companies can be split into equivalent return clases. Thus, the return received from the shares issued by any company, they concuded, is propotional.

 Literature Review

Most of the previous work on those factors that determines the borrowing and dividend decisions of a company concentrated on those factors  that had been predicted by what is popularly known as trade off optimum capital structure theory. The theory is mainly based on the exchange between costs of capital/ financial distress and advatages of tax received from debt financing. As it was discussed by Myers in 1984, the capital structure static trade off theory brings some implications, it says that the true dedt ratio tends to revert toward an optimum or a target, thus, it makes predictions on a cross sectional relationship between asset risks and debt ratios, profitability, size, asset type and tax status (Goodyear 1913, p. #) . The evidence collected from the empirical literature makes confirmation on these predictions, that companies/businesses that play in the same industry and which face uniform conditions, risk features  as well as tax status, tend to have uniform leverage ratios. The evidence collected from the study supported the negative effect of firm risk on corporate  debts decisions. The next part involves discussing the various determinants of capital structure as formulated by various scholars. It will further analyse the relationship that exists between these capital structure determinants and  gearing level of a company. The study will also determine the relationship that is there between the dividend policy and the prices of shares of small Green businesses.

  Profitability

Most of the theoretical work done after the Modigliani and Miller in 1958 has not reached consistent  predictions over the relationship that exists between leverage and profitability. Models based on tax are of the suggestion that profitable businesses borrow a lot if they have to satisfy  their growing needes of shielding income from taxes such as corporate tax. Pecking theory is of the view that businesses will tend to use intenal funding as a priority, and later move to bonds, and, finally, to equity if the situation demands that they do so. Therefore, companies that are profitable don’t need to keep gearing levels that are high.

Theoretical study shows that profitabilty is not related to leverage level, but empirical studies show a different case that  leverage is in a way  negatively related to profitability (Elliot 2004, p. 49)

 Size

There exist very confusing results on the relationship that exists between leverage and size of a business. The empirical studies of Chung (1993) and Sorensen (1986)  conluded that no systematic association exists between business size and its capital structure. On the other hand, Waston, Keasey and Storey (1987), as well as Hall, Hutchinson and Chittenden (1996)  were of the view that size of a firm has a significant effect on its capital structure. Volatility

Business risk shows some probability on the future financial distress that a business may find itself in, and, therefore, it is expected that a negative relationship exists  between volatility and leverage. The predictions shed some light in a way, it is reasonable to say that a business which  has a larger  variance in income, shows lower gearing ratios, since there is higher chances of bankruptcy. It is, therefore, reasonable to say that an expected rise in income variance would result to a fallin gearing ratio. Therefore, if there is a negative coefficient on business risk, this makes act as an indication of financial distress, as well bankruptcy cost existing in a firm.

Problem Defition

The purpose of this study is to investigate the correllation that exists between gearing levels and share prices from the data collected from Small Green businesses. The study intends to determine how is the Modigliani and Miller’s theory on the irrelevance hypothesis related to these two factors in determination of capital structure of a company. The data will be analysed, and then hypothesess will be drawn to see the correlation that exists between these factors in determination of capital structure of a company. Thus, the main aim of this paper is to test the relevance  of the Modigliani and Miller’s irrelevance hypothesis (Friedlob 1996, p. 43).

 Results and Hypotheses

The study involved the seting of  various null hypotheses on relationship that exists between share prices, gearing level & other determinants of capital structure and capital structure of the small Green businesses (Berezin 2005, p. 34). The results of the study have been summarised in the following tables and graphs on the share prices and gearing ratios from the data obtained from Small Green businesses. They show a clear retionship that exists between the data obtained and the factors under consideration. The hypotheses have been drawn  based upon all the factors that determine optimum capital structure of a given firm (Gove 1961, p. 54).

 Conclusion

The study shows that Modligiani and Miller theory  of irrelevance  hypotheses is not relevant in determination of capital structure of the firm . The study which involved investigation of whether the share prices and gearing ratios are determinants of  capital structure, showed that thay are irrelevant in making capital structure decisions.