Criticism of the traditional view

The validity of the traditional position has been questioned on the ground that the market value of the firm depends upon its net operating income and risk attached to it.

The form of financing can neither change the net operating income nor the risk attached to it. It simply changes the way in which the income is distributed between equity holders and debt- holders. Therefore, firms with identical net operating income and risk, but
differing in their modes of financing should have same total value. The traditional view is criticized for implying that the totally of risk incurred by all security – holders of a firm can be altered by changing the way in which this totality of risks are distributed among
the various classes of securities.

Modigliani and Miller also do not agree with the traditional view. They criticized the assumption that the cost of equity remains unaffected by leverage up to some reasonable limit. They assert that sufficient justification does not exist for such an assumption. They do not accept the contention that moderate amounts of debt in “sound firms” do not really add very much to the “riskiness” of the shares. However the argument of the traditional theories that an optimum capital structure exists, can be supported on the two counts; the tax deductibility of interest changes and market imperfections

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