Capital Structure Theory – Modigliani and Miller

(MM) Approach
Modigliani and Miller, two professors in the 1950s, studied capital-structure theory intensely.
From their analysis, they developed the capital-structure irrelevance proposition. Essentially,
they hypothesized that in perfect markets, it does not matter what capital structure a company
uses to finance its operations. They theorized that the market value of a firm is determined by
its earning power and by the risk of its underlying assets, and that its value is independent
of the way it chooses to finance its investments or distribute dividends.
The basic M&M proposition is based on the following key assumptions:

 No taxes
 No transaction costs
 No bankruptcy costs
 Equivalence in borrowing costs for both companies and investors
 Symmetry of market information, meaning companies and investors have the same
information
 No effect of debt on a company's earnings before interest and taxes

Of course, in the real world, there are taxes, transaction costs, bankruptcy costs,
differences in borrowing costs, information asymmetries and effects of debt on earnings.

To understand how the M&M proposition works after factoring in corporate taxes, however,
we must first understand the basics of M&M propositions I and II without taxes.

Modigliani and Miller's Capital-Structure Irrelevance Proposition

The M&M capital-structure irrelevance proposition assumes no taxes and no bankruptcy

costs. In this simplified view, the weighted average cost of capital (WACC) should remain
constant with changes in the company's capital structure. For example, no matter how the firm
borrows, there will be no tax benefit from interest payments and thus no changes or benefits
to the WACC. Additionally, since there are no changes or benefits from increases in debt,
the capital structure does not influence a company's stock price, and the capital structure
is therefore irrelevant to a company's stock price.

However, as we have stated, taxes and bankruptcy costs do significantly affect a company's
stock price. In additional papers, Modigliani and Miller included both the effect of taxes and
bankruptcy costs.

Modigliani and Miller's Tradeoff Theory of Leverage

The tradeoff theory assumes that there are benefits to leverage within a capital structure
up until the optimal capital structure is reached. The theory recognizes the tax benefit from
interest payments - that is, because interest paid on debt is tax deductible, issuing bonds
effectively reduces a company's tax liability. Paying dividends on equity, however, does not.
Thought of another way, the actual rate of interest companies pay on the bonds they issue is
less than the nominal rate of interest because of the tax savings. Studies suggest, however, that
most companies have less leverage than this theory would suggest is optimal.

In comparing the two theories, the main difference between them is the potential benefit from
debt in a capital structure, which comes from the tax benefit of the interest payments. Since the
MM capital-structure irrelevance theory assumes no taxes, this benefit is not recognized, unlike
the tradeoff theory of leverage, where taxes, and thus the tax benefit of interest payments, are
recognized.

In summary, the MM I theory without corporate taxes says that a firm's relative proportions of
debt and equity don't matter; MM I with corporate taxes says that the firm with the greater
proportion of debt is more valuable because of the interest tax shield.

MM II deals with the WACC. It says that as the proportion of debt in the company's capital
structure increases, its return on equity to shareholders increases in a linear fashion. The
existence of higher debt levels makes investing in the company more risky, so shareholders
demand a higher risk premium on the company's stock. However, because the company's
capital structure is irrelevant, changes in the debt-equity ratio do not affect WACC. MM II
with corporate taxes acknowledges the corporate tax savings from the interest tax deduction
and thus concludes that changes in the debt-equity ratio do affect WACC. Therefore, a greater
proportion of debt lowers the company's WACC.

Capital Structure Theory – Modigliani and Miller

(MM) Approach
Modigliani and Miller approach to capital theory, devised in the 1950s advocates capital
structure irrelevancy theory. This suggests that the valuation of a firm is irrelevant to the
capital structure of a company. Whether a firm is highly leveraged or has lower debt
component, it has no bearing on its market value. Rather, the market value of a firm is
dependent on the operating profits of the company.

The capital structure of a company is the way a company finances its assets. A company
can finance its operations by either debt or equity or different combinations of these two
sources. The capital structure of a company can have a majority of debt component or majority
of equity, only one of the 2 components or an equal mix of both debt and equity. Each approach
has its own set of advantages and disadvantages. There are various capital structure theories,
trying to establish a relationship between the financial leverage of a company (the proportion
of debt in the company’s capital structure) with its market value. One such approach is the
Modigliani and Miller Approach.

Modigliani and Miller Approach

This approach was devised by Modigliani and Miller during 1950s. The fundamentals of
Modigliani and Miller Approach resemble that of Net Operating Income Approach. Modigliani
and Miller advocate capital structure irrelevancy theory. This suggests that the valuation of a
firm is irrelevant to the capital structure of a company. Whether a firm is highly leveraged or
has lower debt component in the financing mix, it has no bearing on the value of a firm.

Modigliani and Miller Approach further states that the market value of a firm is affected by
its future growth prospect apart from the risk involved in the investment. The theory
stated that value of the firm is not dependent on the choice of capital structure or
financing decision of the firm. If a company has high growth prospect, its market value is
higher and hence its stock prices would be high. If investors do not see attractive growth
prospects in a firm, the market value of that firm would not be that great.
Assumptions of Modigliani and Miller Approach

 There are no taxes.

 Transaction cost for buying and selling securities as well as bankruptcy cost is nil.
 There is a symmetry of information. This means that an investor will have access to
same information that a corporate would and investors would behave rationally.
 The cost of borrowing is the same for investors as well as companies.
 Debt financing does not affect companies EBIT.

Modigliani and Miller Approach indicates that value of a leveraged firm (a firm which has
a mix of debt and equity) is the same as the value of an unleveraged firm (a firm which is
wholly financed by equity) if the operating profits and future prospects are same. That is,
if an investor purchases shares of a leveraged firm, it would cost him the same as buying the
shares of an unleveraged firm.

Modigliani and Miller Approach: Two Propositions without Taxes

Proposition 1: With the above assumptions of “no taxes”, the capital structure does not
influence the valuation of a firm. In other words, leveraging the company does not increase the
market value of the company. It also suggests that debt holders in the company and equity
shareholders have the same priority i.e. earnings are split equally amongst them.

Proposition 2: It says that financial leverage is in direct proportion to the cost of equity.
With an increase in debt component, the equity shareholders perceive a higher risk to for the
company. Hence, in return, the shareholders expect a higher return, thereby increasing the cost
of equity. A key distinction here is that proposition 2 assumes that debt-shareholders have
upper-hand as far as the claim on earnings is concerned. Thus, the cost of debt reduces.

Modigliani and Miller Approach: Propositions with Taxes (The Trade-Off Theory of
Leverage)

The Modigliani and Miller Approach assumes that there are no taxes. But in the real
world, this is far from the truth. Most countries, if not all, tax a company. This theory
recognizes the tax benefits accrued by interest payments. The interest paid on borrowed funds
is tax deductible. However, the same is not the case with dividends paid on equity. To put it in
other words, the actual cost of debt is less than the nominal cost of debt because of tax benefits.
The trade-off theory advocates that a company can capitalize its requirements with debts as
long as the cost of distress i.e. the cost of bankruptcy exceeds the value of tax benefits. Thus,
the increased debts, until a given threshold value will add value to a company.

This approach with corporate taxes does acknowledge tax savings and thus infers that a change
in debt equity ratio has an effect on WACC (Weighted Average Cost of Capital). This means
higher the debt, lower is the WACC. This Modigliani and Miller approach is one of the modern
approaches of Capital Structure Theory.
THE CAPITAL STRUCTURE DECISION
• The capital structure decision affects financial risk and, hence, the value of
the company.
• The capital structure theory helps us understand the factors most important in
the relationship between capital structure and the value of the company.

Development of the theory of capital structure, beginning with the capital structure
theory of Miller and Modigliani:

Costs of
Asymmetric
Agency Information
Costs
Costs of
Financial
Benefit from Distress
Tax
Capital Deductibility
Structure of Interest
Irrelevance

THE WEIGHTED AVERAGE COST OF CAPITAL

The weighted average cost of capital (WACC) is the marginal cost of raising
additional capital and is affected by the costs of capital and the proportion of each
source of capital:
𝐷 𝐸
WACC = rWACC = [𝑉 𝑟𝑑 (1 − 𝑡)] + [𝑉 𝑟𝑒 ]

Where
rd is the before-tax marginal cost of debt
re is the marginal cost of equity
t is the marginal tax rate
D is the market value of debt
E is the market value of equity
V=D+E

Proposition I without Taxes: Capital Structure Irrelevance

• Franco Modigliani and Merton Miller (MM) developed a theory that helps us
understand how taxes and financial distress affect a company’s capital structure
decision.
• The assumptions of their model are unrealistic, but they help us work through the
effects of the capital structure decision:
1. Investors have homogeneous expectations regarding future cash flows.
2. Bonds and stocks trade in perfect markets.
3. Investors can borrow and lend at the same rate.
 4. There are no agency costs.
5. Investment and financing decisions are independent of one another.

Proposition I without Taxes: Capital Structure Irrelevance

MM Proposition I
The market value of a company is not affected by the capital structure of the company.

• Based on the assumptions that there are no taxes, costs of financial distress, or agency
costs, so investors would value firms with the same cash flows as the same, regardless
of how the firms are financed.
• Reasoning: There is no benefit to borrowing at the firm level because there is no
interest deductibility. Firms would be indifferent to the source of capital and investors
could use financial leverage if they wish.

PROPOSITION II WITHOUT TAXES: HIGHER FINANCIAL LEVERAGE

MM PROPOSITION II: THE COST OF EQUITY IS A LINEAR FUNCTION OF THE

COMPANY’S DEBT/EQUITY RATIO.

• Because creditors have a claim to income and assets that has preference
over equity, the cost of debt will be less than the cost of equity.
• As the company uses more debt in its capital structure, the cost of equity
increases because of the seniority of debt:
𝐷
𝑟𝑒 = 𝑟0 + (𝑟0 − 𝑟𝑑 ) ( )
𝐸
where r0 is the cost of equity if there is no debt financing.
• The WACC is constant because as more of the cheaper source of capital is
used (that is, debt), the cost of equity increases.

INTRODUCING TAXES INTO THE MM THEORY

When Taxes Are Introduced (Specifically, The Tax Deductibility Of Interest By

The Firm), The Value Of The Firm Is Enhanced By The Tax Shield Provided By
This Interest Deduction. The Tax Shield:
- Lowers The Cost Of Debt.
- Lowers The WACC As More Debt Is Used.
- Increases The Value Of The Firm By Td (That Is, Marginal Tax Rate
Times Debt)
INTRODUCING COSTS OF FINANCIAL DISTRESS
• Costs of financial distress are costs associated with a company that is having
difficulty meeting its obligations.
• Costs of financial distress include the following:
- Opportunity cost of not making optimal decisions
- Inability to negotiate long-term supply contracts.
- Loss of customers.
• The expected cost of financial distress increases as the relative use of debt financing
increases.
- This expected cost reduces the value of the firm, offsetting, in part, the benefit
from interest deductibility.
- The expected cost of distress affects the cost of debt and equity.
Bottom line: There is an optimal capital structure at which the value of the firm is maximized
and the cost of capital is minimized.

AGENCY COSTS

• Agency costs are the costs associated with the separation of owners and
management.
• Types of agency costs:
- Monitoring costs
- Bonding costs
- Residual loss
• The better the corporate governance, the lower the agency costs.
• Agency costs increase the cost of equity and reduce the value of the firm.
• The higher the use of debt relative to equity, the greater the monitoring of the
firm and, therefore, the lower the cost of equity.

COSTS OF ASYMMETRIC INFORMATION

• Asymmetric information is the situation in which different parties have different
information.
- In a corporation, managers will have a better information set than
investors.
 - The degree of asymmetric information varies among companies and
industries.
• The pecking order theory argues that the capital structure decision is affected by
management’s choice of a source of capital that gives higher priority to sources
that reveal the least amount of information.

THE OPTIMAL CAPITAL STRUCTURE

We cannot determine the optimal capital structure for a given company, but we know
that it depends on the following:
• The business risk of the company.
• The tax situation of the company.
• The degree to which the company’s assets are tangible.
• The company’s corporate governance.
• The transparency of the financial information.

TRADE-OFF THEORY: VALUE OF THE FIRM

Market
Value
of the
Firm

Debt/Equity
Value of the unlevered firm
Value of the levered firm without costs of…