Exploring Key Financial Theories: Capital Structure, Investment Strategies, Mergers & Acquisitions, and Market Efficiency

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Exploring Key Financial Theories: Capital Structure, Investment Strategies, Mergers &Acquisitions, and Market Efficiency1. The traditionalist school of thought and the Modigliani and Millers school ofthought regarding thetheory of capitalstructure become very similar oncetaxation and bankruptcy costs are introduced’.Discuss.(100 marks)Answer:The traditionalist and Modigliani-Miller (MM) schools of thought on capital structure offerdifferent views on the relationship between a firm's financing decisions and its value. However,when taxation and bankruptcy costs are incorporated, their perspectives converge.1.Traditionalist View: Traditionalists believe that there is an optimal capital structure thatmaximizes the value of the firm. As a firm increases its debt, its cost of equity rises, but thetax shield from interest payments (due to tax deductibility) lowers the firm's overall cost ofcapital up to a point. Beyond this point, the risk of bankruptcy increases, which raises costs,leading to an optimal debt-equity mix.2.Modigliani and Miller (MM) Theory: MM, in their initial theory, argued that in a perfectmarket (no taxes, bankruptcy costs, or asymmetric information), capital structure doesn'taffect a firm's value. However, MM later revised their model to account for taxes. Theyrecognized that debt financing provides a tax shield because interest payments are tax-deductible, and this can increase the firm's value. However, as leverage increases, so dobankruptcy costs, which can offset the benefits of the tax shield.3.Convergence with Taxation and Bankruptcy Costs:oTaxation: Both schools agree that the tax shield from debt increases the value of afirm. The traditionalist school incorporates this directly into the optimal capitalstructure, while MM acknowledges that debt value increases with taxation butbecomes more complex with bankruptcy risk.oBankruptcy Costs: MM and the traditionalists both agree that as debt increases, theprobability and costs of bankruptcy rise, which diminishes the benefits of debtfinancing. This cost curtails the optimal level of leverage, leading both schools toconverge on the idea that capital structure should balance tax advantages andbankruptcy costs.In conclusion, once taxation and bankruptcy costs are considered, both schools align in recognizingthe trade-off between the tax benefits of debt and the risks of financial distress, resulting in a similarconclusion that there exists an optimal capital structure.2. There are various ways in which investors looking to invest in the stock marketselect securitieswith the goal of trying to outperform the market. Discuss thedifferent trading strategies along withpotential problems that they mayencounter(100 marks)

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