Problem formulation: This paper will examine how the capital structure of firms affects their market valuation by applying the Modigliani-Miller theory on Swedish listed companies in a boom and a recession. The study will examine whether it is possible to draw any conclusions as to whether companies with high debt to equity ratios are valued lower in a recession, in comparison to companies with low debt to equity ratios.
Purpose: To empirically test the Modigliani-Miller theory of capital structure in a boom and a recession in order to see if the companies’ market value is affected differently depending on whether they have a high or a low debt to equity ratios.
Methodology: The essay has a deductive and a quantitative methodological approach. Data analysis was done through a correlation analysis, a regression analysis and a hypothesis testing.
Theory: The Modigliani-Miller theory of capital structure with taxes states that companies with a high debt to equity ratios has a higher value. One of the risks with a high level of debt could be that during a financial downturn companies have more difficulty realizing capital and are thus more likely to go bankrupt.
Conclusions: The study shows results that are contrary to the Modigliani-Miller's theory; all the correlation analyses between debt to equity ratios and market value are negative. The strongest negative correlation can be found in the measurements at the end of 2009 when the impact of the recession is noted in the companies' financial reports. It should also be noted that companies with low debt to equity ratios fared proportionately better than the highly leveraged, with respect to the market valuation. The study also shows that high debt to equity ratios has a negative impact on return on equity during the recession.