'A firm's stock price is not related to its mix of debt and equity financing.' Do you agree with this statement? Explain.

According to theory of modern financial management by Modigliani and Miller, the value of a firm depends solely on its future earnings stream, and hence its value is unaffected by its debt/equity mix. Modigliani and Miller concluded that a firm's value stems from its assets, regardless of how those assets are financed. MM Hypothesis was based on restrictive set of assumptions, including perfect capital markets (which implies zero taxes). They used an arbitrage proof to demonstrate that capital structure is irrelevant. If debt financing resulted in a higher value for the firm than equity financing, then investors who owned shares in a leveraged (debt-financed) firm could increase their income by selling those shares and using the proceeds, plus borrowed funds, to buy shares in an unleveraged (all equity-financed) firm. The simultaneous selling of shares in the leveraged firm and buying of shares in the unleveraged firm would drive the prices of the stocks to the point where the values of the two firms would be identical. Thus, according to MM Hypothesis, a firm's stock price is not related to its mix of debt and equity financing. However, according to Net income approach given by Durand, the capital structure decision is relevant to the valuation of the firm. As such a change in the capital structure causes an overall change in the cost of capital and also in the total value of the firm. A higher debt content in the capital structure means a high financial leverage and this results in decline in the overall or weighted average cost of capital. This results in increase in the value of the firm and also increase in the value of the equity shares. In an opposite situation, the reverse condition prevails. Assumptions of this approach are: 1. Corporate taxes do not exist 2. Debt content does not change the risk perception of the investors. 3. Cost of debt is less than cost of equity i.e., debt capitalization rate is less than the equity capitalization rate.