Financial management Assignment Example | Topics and Well Written Essays - 3000 words

Financial management - Assignment Example In a perfect market, it is assumed that no taxes are imposed and interest rates are derived by the market demand and supply function (Layton, Robinson & Tucker 2012, p. 895). If we consider a perfect competition in the market, an investor would be indifferent of the capital structures followed by each firm. The M&M theory suggests that in a tax-free economy, capital structure becomes irrelevant to the value of the firm. Some assumptions that the theory makes include: Investors are concerned about the returns or future cash inflows. Hence, they expect the same whether the investment is made in bonds or equity. As a result, investors would make decisions based on the firm’s value. Debt and equity components are traded in perfect markets, such that the transaction costs, taxes and bankruptcy costs are nil. Competitors, in a perfect competition market cannot set their own price for similar product offerings. Moreover, investors do not bear the burden of transaction costs leading to their indifference to moving funds from one company to the other. Keeping an eye on the above discussion, it can be concluded that investors would go for an geared company if they are interested in the investment returns. In the case provided, Aguia seems to be a more lucrative opportunity for the investors. Aguia, being a geared company will have lower cost of capital and have higher expected returns in future. Since, it was assumed and provided above that investors are only concerned about the future cash flows, a rational investor would prefer a geared firm i.e. Aguia over the un-geared firm i.e. Pomba, in our case. In addition, a rational investor can make decision on future prospects and plans of the management. Let’s assume that Pomba plans to switch toward debt financing, it might be a more attractive option compared to Aguia as it has higher profit margins comparatively. Hence, financing arrangements in a