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Modigliani Miller Theorems: Core thinking

for capital structure

Paul Laux

September 2010

Learning Goals

Whats the point? What should you know? What should you be able to do?

Understand the goal of M&M thinking


Know the statements made by M&M I & II
Understand how arbitrage pressures are a key force behind M&M out-
comes

Understand how M&M thinking relates to CAPM thinking


Understand why violations of M&M might come about in practice

Sections of the presentation

Contents

1 Theme 2

2 Introduction 2

1
3 A straw man 11

4 Capital structure irrelevance in an idealized world 14

4.1 Firm value (M&M I) . . . . . . . . . . . . . . . . . . . . . . . . . 14

4.2 M&M I: Practical Implications . . . . . . . . . . . . . . . . . . . . 20

5 M&M II: Capital structure & WACC 21

6 Destroying the Straw Man (Inc.) 24

7 The case of risky debt 26

8 Conclusion 26

2
1 Theme

"Would you like that pizza cut into six pieces or eight, sir?"
"EightIm really hungry."
Yogi Berra.

"Youd have more pieces but not more pizza."


Merton Miller.

2 Introduction

Capital structure

What is it? Why might it be important for firm value?

Mini-outline Points

Capital structure definition

Strong regularities suggest a policy at work; economic thinking suggests


optimal policies

Our job is to understand the policies

Capital structure

What is it? Why might it be important for firm value?

Capital structure definition

Broadest level: Debt vs. equity

Relative levels and changes in levels

Many specific aspects: maturity structure, fixed-vs-floating, senior-vs-debenture,


mazzanine finance, cash holdings implications, derivatives asset use implica-
tions, ...

3
Capital structure

What is it? Why might it be important for firm value?

Strong regularities suggest a policy at work; economic thinking suggests


optimal policies

Specific firms over time

Specific industries

Industrial vs. service vs. financial firms

Younger vs. older firms

Specific countries

Categories of countries

Capital structure

What is it? Why might it be important for firm value?

Our job is to understand the policies

We begin by thinking about when there would not be a role for policy

Differences between the no role world & the one we live in help us know

What generates the role, &


What the role could be

4
Example: Industry variation (1)

Note overall average debt ratio; note nature of some outlier industries

Example: Industry variation (2)

Note overall average debt ratio; note nature of some outlier industries

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An example

German vs. U.S. firms, comparison on average

Mini-outline Points

In Germany, relatively less debt. Why?

Differences in banking system

Differences in bankruptcy law

Overall, both banking & legal system setups are conducive to more equity in
Germany

An example

German vs. U.S. firms, comparison on average

In Germany, relatively less debt. Why?

Differences in banking system

German banks more often strategic equity investors

Bankers watch well, reduce managerial agency costs of equity

Implication: Shareholders prefer more equity

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An example

German vs. U.S. firms, , comparison on average

In Germany, relatively less debt. Why?

Differences in bankruptcy law

Shareholders retain more power in US

Fast liquidation unlikely in US; going concern bias

Agency problems in distress resolved more in favor of debtholders in Germany

Implication: Shareholders shy away from debt

Overall, German banking & legal set-ups conducive to more equity

I will speak of financial capital structure as a matter of debt versus equity.


Debt and equity do comprise most of corporations financing. Corporations
financial capital structures additionally involve a wide variety of other secu-
rities. Preferred stock, interest rate swaps, warrants, convertible debentures,
and so on are all part of the capital structure choice. Firms use each of these
securities to achieve some benefit that cannot be gotten with other financing
vehicles, or to avoid some cost. The general discussion in this note is useful in
considering firms choice about including complex or specialized securities in
the capital structure. The general discussion identifies the major types of costs
and benefits that are affected by financing choices.

Capital structure, defined in its broadest terms, is a firms way of financing


its economic balance sheet in terms of debt versus equity. Capital structure is
perhaps a firms most fundamental financial decision. To get an introductory
sense for the economics of capital structure, I take an example about the typical
capital structure choices in major countries drawn from Rajan and Zingales
(1995). We will study this article in more depth in our Scientific meeting.

German firms as compared to U.S. firms tend use much less debt. Why
might that be?

7
Some reasons relate to the way German banks are involved in the econ-
omy (such as owning equity and underwriting stock issues). Bank debt bring
very effective monitoring of management into the picture (bankers watch well),
and thus helps to militate some of the manager-owner agency problems that
come with extensive equity financing. This results in equity finance being more
workable, and so German firms use relatively more of it.

There is another reason for the German-U.S. capital structure contrast. U.S.
bankruptcy laws seem to be strongly oriented toward maintaining the firm as a
going concern. The U.S. law has an entire set of procedures that are oriented to-
ward reorganization rather than liquidation. Under the reorganization proce-
dures of the US bankruptcy code, a firms management and shareholders seem
to have the bargaining advantage. For example, the firm (not the creditors)
proposes a reorganization plan, and may take six months to do so. The cred-
itors can essentially do nothing until this plan is filed. As a result of this and
many other advantages, violations of absolute priority are commonplace in
the U.S. In Germany, the bankruptcy laws are more creditor-friendly. The firm
has only a short time to file a reorganization plan, and creditors are not stayed
by it. It is likely that part of the reason that German firms shy away from debt is
that this creditor-friendly environment increases the costs of financial distress
for firms with heavy debt.

I could state this conclusion in terms of principal-agent language. The Ger-


man approach seems to resolve in favor of the debtholders the agency problem
that debt-holders face when they trust stockholders to run the firm as their
agents. And as a result the stockholders choose to shun the debtholders to a
greater extent than in the US, a country that is more willing to let

A brief mention, in case you do not know: Absolute priority is the legal
ordering of claims on the firms assets. Secured creditors are supposed to stand
first in line to be paid, then unsecured creditors, the preferred shareholders,
and then, after everyone else has been paid, common stockholders get the
residual. Violations of absolute priority mean that common stockholders do
better than the rules say they should.

In studying capital structure, we are standing on the shoulders of giants.


For example, in deciding to focus on agency problems in the introduction, I
have been guided by 50 years of formal research on capital structure. This body
of research teaches that the firms capital structure is an important strategic
choice, and that there are costs to getting it wrong. In choosing, a firm needs to
consider the costs of too much debt and the costs of too much equity, and think
about which potential costs are most relevant to its situation.

8
Modigliani and Miller Theorems

Irrelevance leads to relevance

Nanos gigantium humeris insidentes

per Isaac Newton, among others

M&M Theorems are starting-place thinking

Ask when capital structure would be irrelevant for value & cost of
capital
Those conditions must be violated if capital structure is very rele-
vant

M&M thinking is a way of shining a light on the important places

Not literally a description of reality, but where to look to understand


reality

The rest of this note is devoted to describing the conclusions of some of the
first giants in this area, and to showing the circumstances in which there are
NO costs to getting the capital structure choice wrong. No costs to getting
it wrong means no reduction in the value of the firm and no increase in
the overall cost of capital. These ideas are often summarized in the statement
that capital structure is irrelevant under the conditions to be described. The
point of examining the circumstances in which capital structure is irrelevant is
to focus our thinking on the issues that DO make capital structure relevant by
eliminating the issues that do not.

What the giants changed

A before and after story

Mini-outline Points

1. Modigliani and Miller (1958, 1963)


2. Before
3. After
4. Much after

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What the giants changed

A before and after story

Modigliani and Miller (1958, 1963)

Before

Vague idea of an optimal capital mix

Notion that outside capital is troublesome

Notion that fixed payments add risk

Looking out the window

What the giants changed

A before and after story

After

Focus on specific market imperfection trade-offs driving the optimal


mix

taxes vs. bankruptcy costs


conflicts between shareholders & managers vs. between sharehold-
ers & bondholders
informational imbalances & barriers
or combinations of these

Optimal for what?

Value of the firm (M&M Proposition 1)


Cost of capital (M&M Proposition 2)

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What the giants changed

A before and after story

Much after

Nobel Prizes

Modigliani: also for other work in life cycle consumption & savings, and
economic growth
Miller: mainly for this work, though shared with others who worked on
portfolio formation, risk, & expected return

Sparked static trade-off theory and pecking order theory

In the sections that follow, I discuss the ideas that brought finance into
the modern age: The Modigliani-Miller Propositions. The seminal papers are
Modigliani and Miller (1958) and Modigliani and Miller (1963). Prior to the
work of M&M, the relationship between capital structure and the cost of capi-
tal was considered to be complex and mysterious. Executives had a vague idea
that there was some "optimal" mix of debt and equity that would minimize
their companys cost of capital. But they had only the roughest of ideas of how
to determine it.

M&M and those that extended their reasoning came along and reasoned,
very simply and very convincingly, that executives ought to look to market
imperfections as the source of an optimal capital structure. Market imper-
fections are real-world features like taxes; bankruptcy costs; conflicts between
owners and managers, or between shareholders and bondholders, due to dif-
fering goals. Why? Because, they showed us, without any market imperfec-
tions capital structure affects neither the value of the firm, nor the value of its
common stock, nor the weighted average cost of capital.

For these insights, Modigliani and Miller won separate Nobel Prizes. In
awarding Nobel Prizes for this revolutionary work in finance, the Committee
cited the wide-spread effect that M&M have had, not just on the academic sci-
ence of finance, but especially on the everyday practice of business finance.

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3 A straw man

Straw Man Incorporated

Setting for a claim that we can refute, and learn in the process

Assume no market imperfections


All-equity firm

Considers floating debt and repurchasing shares


Hopes to increase value and decrease cost of capital

To see how an argument works, it sometimes helps to have an alternative


position to destroy. So let me develop a straw man that we can destroy. We
will take a lot of guidance from the process of destroying him.

For the straw man case, assume there were no taxes or other market im-
perfections. Nothing gets in the way of market prices reflecting value directly
and completely.

Impeded information flows, transactions costs, and principal-agent prob-


lems are all market imperfections, and are therefore all ruled out in my exam-
ple. Taxes are a market imperfection because they cause market prices to re-
flect less than the value the firm has produced (how much less depends on how
much the government takes). While bankruptcy in its pure form is not a market
imperfection (for it implies a simple transfer of ownership from stockholders
to bondholder), bankruptcy in practice involves many market imperfections.
Not the least of these is the fact that some of the bankrupt firms resources are
passed to lawyers and that its management is heavily involved in bargaining
for survival instead of setting the firms strategy.

The reason for abstracting from market imperfections is to lay out, as cleanly
as possible, a framework for reasoning. We will add back some imperfections
later, starting with taxes.

What does the straw man look like? Consider a company that has no debt
in its capital structure. Ill call the company Straw Man Incorporated (I am very
imaginative!).

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Portrait of the Straw Man

Details of the situation

Straw Man setup

Facts

E(OCF ) =e10 million in perpetuity, with (OCF ) =e2.5 million


Assets =e10 million
2 million shares outstanding
e = 1.5, r f = 4%, MRP = 8%

Calculate ROA, ROE, and EPS for a normal year

Also for 1- outlier year (upside & downside)

It happens that cash flows and earnings are the same thing for this firm, for
its book depreciation is exactly equal to the new investment needed to keep the
firm operating in its current fashion.

Straw Mans president is considering an open-market stock repurchase.


The funds for the repurchase will be provided by the firms first-ever bond
issue. This is effectively a debt for equity swap. The president is feeling
especially good about this proposal because she believes it to be an improve-
ment over one suggested by her hotshot investment banker has suggested. The
banker has suggested she issue the bonds and use the proceeds to pay a special
dividend to shareholders. This would have increased the companys return on
equity exactly as under the presidents proposal, but would not have the addi-
tional benefit of increasing the earnings per share by a greater amount (due to
less shares outstanding).

Presidents proposal

Details of the proposal; what effects on performance numbers?

Straw Man setup Straw Man leverage chart (choose sheet manually if necessary)

1
Borrow 3 of the firms asset value
1
Use proceeds to repurchase 3 of the market value of shares
Under the proposal

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calculate ROA, ROE, and EPS for a normal year
Also for 1- outlier year (upside & downside)
Plot EPS as a function of OCF

Even better, the president believes that her plan will increase the stock price
and the current value of the firm. She believes that the firms expected earnings
per share will be higher under her plan, and that investors will therefore assess
a greater present value of future earnings than before.

Presidents proposal

What expected effect on stock price, in her view?

Straw Man setup Straw Man with M&M (choose sheet manually if necessary)

Make calculations to argue stock price will increase

Focus on the capitalized value of the new E( EPS)

To make this point, what must be held constant?

Would it really be so?


Explore M&M Propositions to see why not

On this first examination, it looks like the president has a point. The capital
market likes earnings (because they are the same as cash flows for this firm).
By financing 13 of the firm with debt, at a cost of debt that is less than the return
on assets, she can lever the earnings to increase the expected ROE. By also
repurchasing some shares, she can increase the expected EPS, too Good deal,
right?

Thats the straw man. Lets see if we can burn it. To do so, we will leave
Straw Man Incorporated for a few minutes and visit with Modigliani and Miller.
Then we will return to consider Straw Man.

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4 Capital structure irrelevance in an idealized world

4.1 Firm value (M&M I)

Setup for M&Ms arguments

What are firms like?

Financing choices are equity and debt

Debt is perpetuity-style (keeps calcs simple)


Debt is risk-free (keeps calcs simple)

Expected cash flow constant & variance of cash flow positive

As above, keeps calcs simple; not essential

Managers choose financing mix to maximize shareholder value

EU = VU ; unlevered firm equity is value of unlevered firm


EL = VL D; levered equity value is levered firm value less debt

M&Ms argument: Intuition

Can equity value be increased with debt?

Mini-outline Points

1. To maximize E, maximize V
2. What is firm-value-maximizing choice?
3. If leverage changed firm value, what would investors do?

4. What is the arbitrage argument?


5. Statement of M&M I

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M&Ms argument: Intuition

Can equity value be increased with debt?

To maximize E, maximize V

Holds for both unlevered and levered cases

No stock-debt claimant conflict of interest

Why?
coupon
D= r f , a number known to all and

V = E + D; D is unaffected by capital structure, as debt is risk-free)

What is firm-value-maximizing choice?

There isnt one; debt doesnt matter for value

M&Ms argument: Intuition

Can equity value be increased with debt?

If leverage changed firm value, what would investors do?

If borrowing increased firm value, investors would refuse to buy the shares

They could create a pay-alike portfolio cheaper by owning another firm


with the same cash flow and risk structure, and borrowing on their own
account
No price support from buyers until price comes back down

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M&Ms argument: Intuition

Can equity value be increased with debt?

If leverage changed firm value, what would investors do?

If borrowing decreased firm value, investors would refuse to sell the shares

The pay-alike portfolios that are the risk-equivalent alternative for their in-
vestment funds would be an unattractive alternative
No sellersbuyers would bid up price

M&Ms argument: Intuition

Can equity value be increased with debt?

What is the arbitrage argument

Suppose firm adds e1 to V with financing choice

You can sell firms shares, buy risk-alike firms shares for e1, and borrow to du-
plicate the debt position yourself

You keep the Euro

Arbitrageurs will drive the price back down

Statement of M&M 1

VL = VU and EL = EU

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What is the stock-debt financing mix that will maximize the value of the
firm? M&M Proposition I says there isnt any particular one. The financing
mix doesnt matter.

How do we know? Well, suppose it did. Suppose a company could add


e1 to its total value (and, by implication, its stock value) by using some debt
financing instead of by financing with 100 percent equity. Then you, as a savvy
shareholder of that company, could search out another company which has the
same expected cash flows to investors as did the first one before taking on the
debt. (In M&M language, this is one that is in the same "risk class.") Make sure
these cash flows have the same risk as those of the first firm, too. This second,
unlevered, company will be selling for e1 less than the first, levered, company.
This is because it is the same in all things that count except for the debt.

What will you do? Sell your stock in the levered firm. By doing this, you
can raise enough money to by the stock of the unlevered firm and have e1 left
over. Put the e1 in your pocket. Go to your bank or broker and borrow exactly
the same amount on the same terms as the levered company did. Between the
shares of the unlevered company and your borrowing, you have put together
a portfolio that has exactly the same cash flow characteristics as the levered
company you sold. So you are even on that score. Why did you do this? Put
you hand in your pocket and feel the e1. Thats why.

If the levered firm still sells for e1 more than the unlevered firm, even af-
ter your selling pressure on the price, then the new owner will replicate your
scheme. And so will the owner after her. And so on. Eventually, all this selling
will drive the price down. The selling will continue until the two companies,
the levered and the unlevered one, sell for the same price. In the end, the lev-
ering of the firm cannot affect its value. This is M&M Proposition I.

M&Ms argument for Proposition I is the first important example of an arbi-


trage argument in finance. Arbitrage, as you know, is the profitable trade that
can be accomplished whenever two assets with the same fundamental value
(e.g., same returns in all possible future states of the world) sell for different
prices. In such a situation, you should always buy the asset that is cheap and
sell the one that is dear. In this way, you have income and obligations that
just offset (leaving you exposed to no risks) and you have some money in your
pocket. You have spent no cash of your own, so the money in your pocket is
pure profit. Arbitrage opportunities arise only when at least one relevant asset
is selling for a wrong pricethat is, its price does not make sense given the
price of the other asset.

We could motivate the M&M arbitrage argument a little more formally. This
is what they did back in the 1950s.

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M&Ms portfolios (1)

Two investment strategies with the same payoffs at every time must have the same
upfront investment. Otherwise, arbitrage is attractive

Strategy Investment0 Payo f f t


A. Buy 100% of EU = VU OCFt
of Us shares
B. Buy 100% of EL + D (OCFt r f D ) + r f D
Ls shares & lend D = OCFt

In effect, B undoes Ls leverage in A


Note payoffs are always identical at every point in the future

M&Ms portfolios (2)

Two investment strategies with the same payoffs at every time must have the same
upfront investment. Otherwise, arbitrage is attractive

No arbitrage pricing implies equal Investment0 for A and B

! VU = EL + DL
! VU = EL + DL ! VU = VL
! EU = EL

M&M 1

VL = VU and EL = EU

M&Ms arbitrage play

What if Strategy B (the levered equity) did somehow become higher valued?

Mini-outline Points

1. Sell whats dear, buy whats cheap


2. Big picture
3. Result: M&M 1

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M&Ms arbitrage play

What if Strategy B (the levered equity) did somehow become higher valued?

Sell whats dear, buy whats cheap

Sell Strategy B and buy Strategy A

Operationally, Sell B means sell levered stock and borrow D

Homemade leverage

Net investment: VU (EL + DL ) < 0


Net cash flow at time t: 0

M&Ms arbitrage play

What if Strategy B (the levered equity) did somehow become higher valued?

Big picture

No business risk on OCFs

Using cash that unlevered firm is not paying in interest to pay interest on your
debt

No loss in the future, and a negative investment (inflow!) now

Arbitrage activity pressures EL down and EU up

Result: M&M 1

VL = VU and EL = EU

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4.2 M&M I: Practical Implications

M&Ms purpose (1)

Focus us on what CAN matter for value. What can make M&Ms arguments fail?

Examples

If shareholders cannot borrow on same terms as firm


If firm risks are truly unique
If firm might not pay out cash flows (shaky)

Reality may be close to satisfying assumptions. Consider:

Buying shares on margin; loan well secured; interest rate close to r f


Same-industry firmssimilar risk & value
If firm holds back cash, likely invested at cost of capital; little value
impact

M&Ms purpose (2)

Focus us on what CAN matter for value. What can make M&Ms arguments fail?

If not, firm should

Do borrowing that their investors wish they could do, and payout
the cash
Pay more attention to capital structure when they have more monopoly
position
Look for investors who like a particular payout pattern

The M&M result above is developed in a rather austere setting. Nonethe-


less, it is not just some silly (read: irrelevant) proof. In fact, it is arguably one
of the three most important finance ideas of the past 50 years.8 The value of
the proof is to provide guidance on the conditions in which capital structure
is irrelevant, so that financial managers can better focus their thinking on the
conditions under which it is relevant. In this section I focus on one possible set
of conditions: corporate advantages in borrowing and lending.

Above, I reasoned that an individual investor could undo the leverage of


the levered firm (by lending on personal account) and thus undo the effect of

21
the leverage. The ability to do so implies that the firms leverage is redundant
and cannot add value.
Note the importance of the assumption that firms and investors can borrow
and lend on the same terms. If investors cannot borrow and lend on the same
terms as firms, then the arbitrage proofs will not go through. At first glance, it
is fairly realistic to suppose that investors terms will not be worse than firms.
After all, investors will be borrowing against stock as collateral. Stock is easily
liquidated, unlike the fixed assets that firms use as collateral. Further, stock
can be kept under the watchful eye of the lender (i.e., be held by the broker),
unlike the firms assets which are under the control of the management. In fact
margin loans (loans from brokers to investors to purchase extra shares of stock)
generally carry low rates of interest.
So what might cause M&M I to be violated? Well, lots of things. The real
value of the theorem is to focus us on what those things might be. Were not
quite ready to do that in force at this stage of the discussion, but I can give the
flavor with an example.
In the US, the 1986 Tax Reform Act imposed a constraint on personal lever-
age. Investors can deduct the interest expense on debt incurred to support
investments, but only to the extent that such interest expense does not exceed
investment income by more than a per year limit. If a firm has a lot of share-
holders who are apt to be affected by this constraint, they may represent a
clientele who could benefit from the firm taking on debt. This would require,
of course, that they want debtas they would if they desire to hold a higher
risk-higher return asset than the firms unlevered equity.
The general idea behind the CFOs effort is to add value by satisfying some
clientele whose demands have not been addressed by existing securities, or to
satisfy those demands in a cheaper way than is currently possible. This has
been the goal of a great deal of recent financial innovation, or the creation of
new types of securities (especially derivative securities).

5 M&M II: Capital structure & WACC


Lets continue to develop the M&M arguments. So far, they say that the firms
value is the present value of its cash flows available to suppliers of capital.
Leverage does not change the value of the firm. Leverage does not change the
firms total cash flow. The present valuing is done at a weighted-average cost
of capital. So leverage cannot affect its cost of capital either.
What do I mean by its cost of capital? I mean the expected return that
investors require of the firm. After all, if investors require it, the firm must
provide it to convince them to invest in the first place. We can discuss the cost
of equity capital (re ), the cost of debt capital (r f ), and also the overall weighted
average cost of capital (the WACC).

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Value and the WACC

M&M I has a follow-on cost of capital implication

Leverage does not change operating cash flows

Operations are separate from financing in this thinking


Always so (e.g., internet firms)?

Leverage does not change firm value or equity value, per M&MI

Operating cash flows & values unchanged, so discount rates to transform


one into other also unchanged

This is core idea of M&M II

M&M II: Formal development

Unchanging WACC implies changing cost of equity

From M&M I: WACCL = WACCU


EL D
Definition of WACC for levered firm: WACCL = VL re,L + VL r f
Definition of WACC for unlevered firm: WACCU = re,U
EL D
So re,U = VL re,L + VL r f

Rearranging:
re,L
VL D EL + D D
= EL re,U EL r f = EL re,U EL r f
D
= re,U + EL (re,U rf )
Final expression is M&M II
Cost of levered equity

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M&M II, graphically

More leverage increases risk of equity, increases cost of equity

Change in re offsets any WACC advantage to adding cheaper debt to capital


structure

Proposition II assures us that a firms WACC is unaffected by leverage in


the idealized world. Reasonably, it also shows that the firms equity holders
require a higher expected return as the firm takes on more debt, for they are
then in a riskier position. The effect of more expensive equity is just offset
by the fact that the firm is using more low-cost debt, so that the WACC stays
constant no matter what the capital structure.

How does this square with the CAPMs guidance on the cost of capital (i.e.,
required expected returns for the risk? Very nicely.

M&M II and CAPM

More leverage increases risk of equity, increases cost of equity

Overall cost of capital unaffected, so firms overall (asset) unchanged

assets = e,U

on portfolio is weighted average of assets s

Firm is portfolio: A = D + E (market value)

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So assets = equity&debt

E E
Thus assets = D + E e,L + D+E D

D
! e,L = assets + A ( assets D )
In our riskfree debt case, D = 0

First, notice that the firms overall risk level, call it assets , must be unaf-
fected by the capital structure choice because the firms overall cost of capital
is unaffectedand is therefor the same as the for the equity of the unlevered
firm. This should be intuitive: the firm has not changed the composition of
its assets, and the unlevered firm has a balance sheet where assets (with their
characteristic level of risk) are supported by a single equity claim, which must
therefore have the same risk. Second, remember that, as a matter of statis-
tics,the of a portfolio is just the weighted average of the s of its components
(covariance risk averages!). Assuming the levered firm is financed only with
debt and equity, then the right side of the firms balance sheet is a portfolio
of these two components, with the same average the other side of the firms
balance sheet.

Using this reasoning, the risk of the levered firms equity can be isolated.
It is equal to the asset plus an add-on risk that depends on the firms debt
ratio.

The reason that the cost of equity increases with debt is that its increases
with debt. The increase in the cost of equity, based on its increases risk, is
just enough to offset the cost savings from emphasizing cheaper debt in the
firms capital structure, leaving the overall WACC for the levered firm just the
same as for the unlevered firm. Thus, the M&M theorems are irrelevance
theorems.

6 Destroying the Straw Man (Inc.)

Returning to the Straw Man

I come not to praise Ceaser but to bury him

Straw Burning! (choose sheet manually if necessary)

The President will be disappointed

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If stock price does rise, do A below & opposite of B. Make money?
Buy whats cheap, sell whats dear
Note that B undoes Ls leverage
If stock price falls, do B below & opposite of A. Make money?

Strategy Investment0 Payo f f t


A. Buy 100 U shares 5000 100 OCFt
100
( 2000000 = 0.005%)
B. Buy 67 L shares & lend 67 PL + 1500 ? 5000 100 OCFt 1500r f + 1500r f
e1500(0.05% 1400000) = 100 OCFt

So the President of Straw Man Incorporated does her debt-for-equity ex-


change (remember her?). She watches the stock market for her expected in-
crease in stock price. She is going to be disappointed. Why?
Following the thinking above, consider two strategies. The first strategy is
to buy some of unlevered firms shares, say 100 of them. This would represent
100/2,000,000 = 0.005 percent of the firms shares.
The second strategy is to buy exactly the same proportion of the levered
firms shares, i.e., 0.005 percent of them. This would be 70 shares. The point is
to scale down the holdings according the firms new D/V ratio. The leverage
means that it takes fewer shares (by a factor of 1 - D/V) to control a given
proportion of the firm. In addition, lend some money. Lend just as much on
the 70 shares as the firm borrowed per 70 shares. The point is to generate
interest income that just makes up for the interest expense that the firm has
incurred.

Price pressures
What should B cost? Why?
Straw Burning! (choose sheet manually if necessary)

Buying Strategy B will push price up


Selling (doing the opposite) of strategy B will push price down.
Price pressure pushing price toward 50.
If investors can make & unmake leverage (homemade leverage) on
firms terms, corporate leverage has no lasting stock price effect.
What if investors cannot borrow on those terms?

The details of the arithmetic are laid out in the Excel workbook that accom-
panies this note, available on our Teaching Materials Grid web page.

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7 The case of risky debt

Robustness to risky debt


What if the firm might default on its debt when troubles arise?

D
What happens to the cost of debt? How does it vary with A?

What happens to the risk of equity? The cost of equity?


What happens to M&MI? M&M II?

Lets acknowledge that the there is some probability that the firm will not
be able to pay its debt obligations. And that the chance of default increases
with the amount the firm borrows. This does not change M&M Proposition
I (the one about the total value of the firm) and changes M&M Proposition II
(the one about WACC and described above with a picture) only a little bit. The
modified picture looks like this.
Note that the central part of Proposition II has not changed: the firms
WACC is still invariant to its capital structure. What has changed is that the
cost of debt rises when the firm borrows beyond a certain point. That point
is where the possibility of de-fault becomes more than negligible. However, at
the same point, the cost of equity ceases to rise so fast with debt. In one sense,
this is simply a mechanical result: if the WACC is to stay constant as debt is
added even though the cost of debt is rising, then the cost of equity must rise
less steeply. Proposition II is simply a consequence of Proposition I.
The economic reason that the cost of equity rises less steeply with risky debt
is that the debtholders are then sharing in some of the firms risk. If the firm
does badly, then they might not have their claim paid in full. Since the value of
the firm is invariant to the capital structure, then what is bad for debtholders
must be good for shareholders.

8 Conclusion

Two misconceptions
Can you explain why these are incorrect?

Since r D is generally less than re , a CFO can increase firm value by levering-
up with debt?
Since the firm must make periodic payments to debtholders, but is not
required by law to pay dividends, levering-up reduces firm value.

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References

Modigliani, F. and M. Miller, 1958, The Cost of Capital, Corporate Finance and
the Theory of Corporation Finance, American Economic Review 48, 261-297.

Modigliani, F. and M. Miller, 1963, Corporate Income Taxes and Cost of Capital:
A Correction, American Economic Review 48, 433-443.

Rajan, R. G. and L. Zingales, 1995, What Do We Know About Capital Structure?


Some Evidence from International Data, Journal of Finance 50, 1421-1460.

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