Modigliani and Miller’s 1958

Modigliani and Miller’s 1958 capital structure model argues that it is the core and foundation of modern capital structure thinking (Krueger & Gitman, 2003). According to the theory, the value of a corporation in an efficient market where certain types of charges such as bankruptcy costs, taxes, and agency costs are absent is unaffected by the financing methods in place as long as asymmetric information is available and relevant. Because it does not use a dividend policy or issue stock or debt financial instruments, the theory is known as a capital structure irrelevance principle. Though the theory established in a tax-free territory, the approach has evolved capturing what arises when taxes incorporated into the market. The theory states that increase in interest on debt reduces the taxable income and with that, the value of the firm increases too only if all the other economic frictions suppressed.

The Modigliani and Miller’s theory states that a firm’s value is optimized by a mix of both debt and equity. The theory says that firms of the same capital base where one leveraged and the other one is from equity, the one from leverage will have a higher return in comparison to the other. The theory borrows from the weighted average cost of the capital theory that goes the higher the leverage, the higher the value of the firm and vice versa (Krueger & Gitman, 2003). The above conclusion is made if there are no transaction costs exists and at the same time, individuals and corporations borrow at the same interest rates from financiers.

For the better understanding of the theory, three propositions exist, but the last seems to have a sound impact in the current world as it allows some of the assumptions that are slightly operational but not at all cases. The third proposition states that the value of an optimal organization is when the leverage is not zero and at the same time, not 100%. The proposal says that firms can only fit in this proposition if the individuals and corporations are paying the same interest rate, there are no transactions costs, companies are taxed after meeting the debt costs. Remember that asymmetric information is critical here.

Efficient Market Hypothesis

Efficient Market Hypothesis is a financial model that states that all the information is available at the disposal of all the market participants and the financial operating in such a market have the irregular movements. The model believes that the performance of the financial assets in the market is determined by the current information prevailing in the market other than the previous time’s trends (Krueger & Gitman, 2003). The efficient market hypothesis assumes that there are three categories of the market that are dependent on the strength of the market.

The weak form of Efficient Market Hypothesis. The first assumption the model theory holds is that the public market information is reflected fully in prices and that the performance of the stock doesn’t determine any valuation of the stock (Krueger & Gitman, 2003). In this assumption, it states that trends don’t matter in the pricing of the stock.

The semi-strong efficient Market Hypothesis. The assumption in this form of efficient market hypothesis states that the valuation of stocks in the market determination is through the market and non-market public information (Krueger & Gitman, 2003). The theory assumes that whenever the investors are deciding to invest in stock, they do so based on what the market knows and what the market doesn’t. That means the assumption not only uses information availed but also uses information that not disclosed at such a time.

The strong, efficient market hypothesis. The last form, in theory, states that all the private and public information are fully constituted to make the price of the final stock at such a time (Krueger & Gitman, 2003). The form affirms that all information available or not to the public determines the values of the assets traded in the market.

Application of the theory in the service industry. The service industry is known to share all the information with the public (Krueger & Gitman, 2003). Though that is the case, the efficient market hypothesis tends not to be useful to be used by investors and as such they use trend analysis mostly in their investment. A minor number of investors believe in using the theory, and it’s majorly during Initial Public offers where after that the decision is based on trend analysis.

Capital Asset Pricing Model

The aforementioned is a financial management model that explains the relationship between the systematic risk and unexpected returns for financial assets commonly stocks (Krueger & Gitman, 2003). The model is widely used in the pricing of securities that have an edge to risk. Given the market risk and cost of capital, the expected returns are generated easily. The model helps investors to make investment decisions since all the financial assets have risks and different expected returns apart from financial assets issued by the government. The model by use of the risk-free rate and the systemic risk in the market helps the investors to calculate their expected returns which becomes the tradeoff point of the risk and the returns. From different studies, there has always been the same conclusion where it emerges that the higher the risk, the higher the returns and vice versa (Krueger & Gitman, 2003). Conservative investors prefer the least risky stocks while on the other hand, the aggressive investors invest heavily on the risky stocks as they believe in higher returns based on the speculative mentality that there will be no market downsizing (Krueger & Gitman, 2003). The model discusses the basis of investors pay that arises from; time value for money and the risk involved in investing in the stock.

Capital Asset Pricing Model is an assumption based model that revolves around the following key features among others:

Perfect Information. The model assumes that everyone participating in the financial market has excellent knowledge of every stock traded there (Krueger & Gitman, 2003). The information relates to risk, returns and maturity period among other qualities of the stock.

Investors are myopic. Another axiom that the model holds is that all the investors have the same holding period when it comes to investing in stock or a financial asset.

All Investors make rational decisions. The model also assumes that investors use Markowitz portfolio model as the basis of optimizing the mean variance of the pool of securities invested (Krueger & Gitman, 2003).

The security market is believed to be an entirely competitive market. Additionally, the model considers that the market has many small-scale Investors and also the market investors are also price takers, not price determinants (Krueger & Gitman, 2003).

References

Krueger, T. M., & Gitman, L. J. (2003). Study guide to accompany Principles of managerial finance, twelth edition, Lawrence J. Gitman. Boston, MA: Pearson Prentice Hall.