Capital Structure Theory – Modigliani and Miller(MM) Approach

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:

• %o taxes

• %o transaction costs

• %o Bankruptcy costs

• Equivalence in borrowing costs for both Companies and investors

•Asymmetry of market information, meaning companies and investors have the same information

• %o 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 1 and 2 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’ 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 pays 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 1 theory without corporate taxes says that a firm) s relative
proportions of debt and equity don’t matter MM 1 with corporate taxes says that the firm with the
greater proportion of debt is more valuable because of the interest tax shield.

MM 2 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. 2owever, because the company’ s capital structure is irrelevant, changes in the debt-
equity ratio do not affect WACC.

MM 2 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 1950’s 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 ma6ority of equity, only one of the 7
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 accompany the proportion of debt in the company’s capital structure with its
market value. *ne 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. "his 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 mi" 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.

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

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:
POSITION II WITHOUT TAXES: HIGHER FINANCIAL LEVERAGE

MM PROPOSITION II* THE COST O1 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

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 8Specificall$! The Ta. Deductibility$ Of Interest 5$The 1ir#9! The <value of
The 1ir# Is Enhanced by The Tax Shield Provided by This Interest Deduction. The Tax Shield:

Lower The Cost of Debt%-Lowers The WACC As More Debt Is Use.

Increases The <value of the firm by Tax rate* Debt

INTRODUCING COST 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 ASYMMETIC INFOMATION

•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

Summary: In the Modigliani and Miller theory developed without taxes,
capital structure is irrelevant and has no effect on company value. The
deductibility of interest lowers the cost of debt and the cost of capital for the
company as a whole. Adding the tax shield provided by debt to the
Modigliani and Miller framework suggests that the optimal capital structure
is all debt. In the Modigliani and Miller propositions with and without taxes,
increasing a company’s relative use of debt in the capital structure
increases the risk for equity providers and, hence, the cost of equity capital.
When there are bankruptcy costs, a high debt ratio increases the risk of
bankruptcy. Using more debt in a company’s capital structure reduces the
net agency costs of equity.

The costs of asymmetric information increase as more equity is used

versus debt, suggesting the pecking order theory of leverage, in which new
equity issuance is the least preferred method of raising capital. According
to the static trade-off theory of capital structure, in choosing a capital
structure, a company balances the value of the tax benefit from deductibility
of interest with the present value of the costs of financial distress. At the
optimal target capital structure, the incremental tax shield benefit is exactly
offset by the incremental costs of financial distress. A company may
identify its target capital structure, but its capital structure at any point in
time may not be equal to its target for many reasons. Many companies
have goals for maintaining a certain credit rating, and these goals are
influenced by the relative costs of debt financing among the different rating
classes. In evaluating a company’s capital structure, the financial analyst
must look at the capital structure of the company over time, the capital
structure of competitors that have similar business risk, and company-
specific factors that may affect agency costs.

Good corporate governance and accounting transparency should lower the

net agency costs of equity. When comparing capital structures of
companies in different countries, an analyst must consider a variety of
characteristics that might differ and affect both the typical capital structure
and the debt maturity structure