MM Theory

MM Theory
Capital Irrelevance Theory

Three Main Parts

Firms value is not influenced by capital structure
Debt results in Tax Savings and lower WACC
Bankruptcy Cost

MM Theory- Assumptions
Both individual investors and firms can borrow with the
same level interest, and they can trade the same set of
securities at competitive market prices equal to the
present value of their future cash flows.
There are no taxes, transaction costs, or issuance costs
and the bankruptcy could be ignored as they can always
raise additional fund to avoid bankruptcy.
A firms financing decisions do not change the cash
flows generated by its investments, nor do they reveal
new information about them.

MM Theory- Part I
MM theory proposition 1
In a perfect capital market, the total value of a firm is
equal to the market value of the total cash flows
generated by its assets and is not affected by its choice
of capital structure.

Point A could present a company financed by pure equity. With level of gearing increasing, the cost of equity increases
exactly the same degree that can offset the cheaper debt finance. Therefore the WACC remains the same and so does
market value of the firm.

Firm U

Firm L

Net operating income()

1000

1000

Interest on debt (5%3000)

150

1000

850

Cost of equity

10%

11%

Market value of equity()

10000

7727

Market value of debt ()

3000

Total value of company

10000

10727

WACC

10%

9.3%

Earnings

available

shareholders()

to

MM Theory-Part 1
Per share profit of Firm:LV
The return from Firm:LV =11%77.27=8.50
Per Share Profit from Firm:U
Firm U=10% 100= 10.00

MM Theory-Part 1
If an investor owned 1 percent of the equity of the geared Firm L (77.27),
he could:
Sell his shares in Firm L for 77.27
Borrow 30 at 5%
Buy 1 percent of the shares in Firm:U for 100. And have 7.27 left.
While after the investment above, return from Firm U=10% 100= 10.00

Less: financial cost, interest on debt =5%30 =

(1.50)

Net return
=
8.50

MM Theory-Part 1
Arbitrage Profit 7.27
Individual investors will not have the same interest rate
as companies, and personal borrowings are thought to
be more risky in real market.
Transaction costs should be considered when repeating
the process.
Share price of Firm L will drop with the selling action of
investors and they would find the 7.27 will decrease till

MM Theory-Part II (Tax Shield)

Corporate tax exists in most of countries. Hence, the
things go to different from the MM theory I if considering
the existence of corporate tax. In most of countries,
such as UK, US and so on, interest payments on debt
are tax- deductible.

Item

Firm A

Firm B

Earnings

1500

1500

Interest on debt

500

Taxable income

1500

1000

Corporate tax (30%)

450

300

After-tax earning

1050

700

Cash to investors

Bondholders

500

Shareholders

1050

700

Total

1050

1200

Tax shield

500

MM Theory-Part II
According to the table, the leverage company B which takes the
debt financing has the tax shield 500 pound. The value of the
levered company is equal to the value of the unlevered company
plus the interest tax shield on debt:

VL=VU+TC *D

Where
VL is the value of a levered firm.
VU is the value of an unlevered firm.
TCD is the tax rate (TC) x the value of debt (D)
the term TCD assumes debt is perpetual

MM Theory-Part II
Tax shield can increase companys value

So WACC2 = (1- TC) Kd (D/D+E) +

Ke (E/D+E)

MM Theory-Part II

The cost of debt curve (Kd) from MM first model shifts

downwards to reflect the lower after- tax cost of debt
finance (Kd( 1-CT)

MM Theory-Part II
The existence of tax is a significant performance of
imperfect capital market.
When capital market is not mature, capital structure
change will affect the company's value.
The company has leverage worth more than the value
of the company without leverage

MM Theory-Part II
The high debt will bring a lot of problems along with the
increasing of gearing level, such as bankrupt, agency
problem, tax exhaustion, bankruptcy cost and so on. As
the debt proportion increase, the risk of the capital
increase.

MM Theory-Part III (Bankruptcy Cost)

At high level of gearing, there is a significant possibility
of a company bankruptcy.
Shareholder require a high rate of return to cover the
bankruptcy risk

MM Theory-Part III (Bankruptcy Cost)

Direct bankruptcy costs
Costs of paying lenders
Cost of employing lawyers and accountants to manage the
liquidation process
Indirect bankruptcy costs
loss of sales
Goodwill
financial distress