Introduction
Capital markets play a vital role in mobilizing savings and channeling them into productive investments. They provide a platform where long-term securities like stocks and bonds are bought and sold, facilitating capital formation in an economy. Understanding their functions and concepts like the Modigliani-Miller theorem helps in appreciating how financial markets contribute to economic growth.
Main Functions of Capital Markets in the Economy
1. Mobilization of Savings
Capital markets encourage individuals and institutions to save by offering various investment options such as shares, bonds, mutual funds, and debentures. This converts idle savings into productive capital.
2. Capital Formation
They help in transforming savings into long-term investments by providing funds to businesses, industries, and governments for infrastructure and other developmental projects.
3. Liquidity Provision
Capital markets offer liquidity by allowing investors to sell their securities at any time, thereby increasing their attractiveness.
4. Risk Diversification
By offering a wide variety of securities, capital markets help investors diversify their investments and manage risk better.
5. Price Discovery
The market mechanism helps in determining the prices of financial instruments based on supply and demand. This aids in fair valuation of companies and resources.
6. Transparency and Regulation
Regulated by authorities like SEBI (Securities and Exchange Board of India), capital markets operate under transparent and fair trading norms which protect investor interests.
7. Efficient Allocation of Resources
Capital flows to the most profitable and efficient businesses, promoting innovation and competition in the economy.
8. Encouraging Corporate Governance
Publicly listed companies are required to follow good governance and disclose financial information, ensuring accountability and efficient management.
The Modigliani-Miller Theorem (MM Theorem)
The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller in 1958, is a foundational concept in corporate finance. It states that under certain conditions, a firm’s value is unaffected by its capital structure — i.e., whether it is financed by debt or equity.
Key Propositions
Proposition I (Without Taxes)
In a perfect market (no taxes, transaction costs, or bankruptcy costs), the value of a firm is independent of its capital structure.
Implication: A company cannot increase its value just by changing its mix of debt and equity.
Proposition II (Without Taxes)
The cost of equity increases as the firm increases its debt because the financial risk to shareholders rises. However, the overall weighted average cost of capital (WACC) remains unchanged.
Modigliani-Miller with Taxes
In 1963, the theory was revised to include corporate taxes. Since interest on debt is tax-deductible, the value of a leveraged firm is higher than an unleveraged firm by the present value of tax savings on debt.
Implication: Debt financing provides a tax shield, which increases firm value to some extent.
Assumptions of MM Theorem
- Perfect capital markets
- No transaction costs
- Rational investors
- Firms with equal risk
- No taxes (in initial proposition)
Criticism of MM Theorem
- In reality, markets are not perfect; taxes, transaction costs, and bankruptcy risks exist.
- Capital structure decisions do affect the cost of capital due to market imperfections.
Conclusion
Capital markets play a crucial role in economic development by mobilizing savings, providing investment avenues, and improving financial transparency. The Modigliani-Miller theorem, despite its idealistic assumptions, provides a theoretical foundation for understanding corporate finance and capital structure decisions. In practice, while capital structure does influence firm value, the MM theorem serves as a benchmark in evaluating such decisions under varying market conditions.