Summary Principles Of Corporate Finance - Modigliani And Miller Theory PDF

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Modigliani and Miller Theory...

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Modigliani and Miller Theory M&M “Capital Structure Irrelevance Principle” Definition: It is a financial theory stating that the market value of firm is determined by its earning power and the risk of its underlying assets and is independent of the way it chooses to finance its investment or distribute dividends. It makes no difference whether the firm finances its activities with debt or equity. This means that if there are two firms which are identical except for their financial structures, the first (Firm U) is unlevered: that is, it is financed by equity only. The other (Firm L) is levered: it is financed partly by equity, and partly by debt, the value of the two firms is the same because the cash flows of the two firms are the same. The key Modigliani-Miller theorem was developed in a world without taxes. However when the interest on debt is tax deductible and ignoring other frictions, the value of the company increases in proportion to the amount of debt used. And the source of additional value is due to the amount of taxes saved by issuing debt instead of equity; tax shield. But, is there any optimal level of debt and thus gearing, without reaching financial distress? What is the effect of gearing upon value, risk, and cost of the capital? 1956 theory (No Tax): Proposition 1:

Where,

is the value of an unlevered (un-geared) firm = price of buying a firm financed only by equity, and

is the value of a levered (geared) firm = price of buying a firm that is

financed by some mix of debt and equity. If an investor is considering buying one of the two firms U or L, instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the same amount of money B that firm L does. The eventual returns to either of these investments would be the same. Therefore the price of L must be the same as the price of U minus the money borrowed B, which is the value of L's debt, i.e. Why should investors pay extra for borrowing indirectly (by holding shares in a levered firm) when they can borrow just as easily and cheaply on their own accounts? The two companies with identical assets must at sell equal price because of arbitrage; by this, proposition 1 asserts that gearing does not affect WACC or the value of the company because the two countervailing forces of equity and debt are always in balance. The WACC of a company is always equal to the cost of equity in its ungeared state (Keu) and all investment projects should be evaluated at this rate, since the Value of the company = Operating profit / WACC, and WACC according to MM theory doesn’t affected by level of gearing.

Arbitrage: is the investors’ attempt to profit by exploiting price differences of identical or similar financial instruments, on different markets or in different forms (buying the undervalued and selling the overvalued securities) until reaching equilibrium. Proposition 2: the WACC of the firm is not affected by the capital structure, but the cost of equity (Ke) is. A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt. But the WACC stays the same because the change in the capital structure (D/V and E/V) is exactly offsets by the change in the cost of equity Ke, i.e. the debt, equity and their costs are always in balance.

Here



is the required rate of return on equity, or cost of equity.



is the required rate of return on borrowings, or cost of debt.



is the debt-to-equity ratio.

Proposition II: with risky debt, as leverage (D/E) increases, the WACC (k0) stays constant. The key theoretical assumptions of M&M theory are: 

Earnings are constant in perpetuity and are paid out as dividends.



Perfect capital markets (supply of funds = demand on funds) with no transaction costs, corporate or personal taxes.



All market participants –individual and institutional – have the same credit rating and can lend and borrow at the same rate.



The risk of debt is zero (firm is able to pay its debt, no bankruptcy fear).

Modigliani and Miller received a lot of criticism over their unreal assumptions and particularly the omission of corporation tax, which has a differential impact on debt and equity. The traditionalists say that a moderate degree of financial leverage may increase the expected equity return (Ke), but not as much as predicted by MM’s proposition 2. But irresponsible firms that borrow excessively find (Ke) shooting up faster than MM prediction. Therefore the weighted-average cost of capital declines at first, then rises. It

reaches a minimum at some intermediate debt ratio. Minimizing the weighted-average cost of capital is equivalent to maximizing firm value if operating income is not affected by borrowing. In 1963, M&M proposed an updated version of their two propositions for a world with taxes. With the inclusion of corporation tax in the model, M&M had to drop their assertion of the irrelevance of gearing to value and WACC and recommend gearing up to a level short of financial distress. Proposition 1: States that since the debt of the firm is tax deductible, then the value of the geared company is the same if it all equity financed plus PV of tax shield. Thus; Vg = Vu + Vd*Tc. Theoretically, assuming risk of debt is equal to Zero, MM suggests financing firms with debt up to 100% because it increases the value of the firm. Myers added to the theory the element of probability of bankruptcy, as financial distress occurs when promises to creditors are broken or honored with difficulty. Sometimes financial distress leads to bankruptcy. The costs of financial distress depend on the probability of distress and the magnitude of costs encountered if distress occurs. Therefore, according to Myers, The Value of the firm can be broken into 3 parts; Value if all equity financed plus PV (tax shield) minus PV (costs of financial distress). Proposition 2: States that tax relief on debt makes it cheaper and causes WACC to fall until gearing enters the zone of financial distress. So, as long as the risk of debt equals zero, Ke increases in a linear manner and WACC goes down. However when the firm reaches the financial distress, Kd increases remarkably, WACC starts to increase, and Ke soars. Therefore, YES, Optimum Target Gearing Could be achieved when the firm is levered to a level short of financial distress.

Keg = Keu + (Keu – Kd) (D/E) (1-t) WACC = Ke*E/V + Kd*D/V*(1-Tc) βg = βu + (βu – βd)(D/E)(1-t) Since βd=0 as per M&M assumption => βg = βu + βu(D/E)(1-t)...