Name : Muhammad Nizar Arrofi’

NIM : C1B020096
Class : Financial Management C

Review Capital Structure Decisions Part II

 Who are Modigliani and Miller (MM)?

1. They published theoretical papers that changed the way people thought about financial
leverage.
2. They won Nobel prizes in economics because of their work.
3. MM’s papers were published in 1958 and 1963. Miller had a separate paper in 1977.
The papers differed in their assumptions about taxes.

 What assumptions underlie the MM and Miller models?

1. Firms can be grouped into homogeneous classes based on business risk.
2. Investors have identical expectations about firms’ future earnings.
3. There are no transactions costs.
4. All debt is riskless, and both individuals and corporations can borrow unlimited amounts
of money at the risk-free rate.
5. All cash flows are perpetuities. This implies perpetual debt is issued, firms have zero
growth, and expected EBIT is constant over time.
6. MM’s first paper (1958) assumed zero taxes. Later papers added taxes.
7. No agency or financial distress costs.
8. These assumptions were necessary for MM to prove their propositions on the basis of
investor arbitrage.

 When Miller brought in personal taxes, the value enhancement of debt was lowered.
Why?
1. Corporate tax laws favor debt over equity financing because interest expense is tax
deductible while dividends are not.
2. However, personal tax laws favor equity over debt because stocks provide both tax
deferral and a lower capital gains tax rate.
3. This lowers the relative cost of equity vis-a-vis MM’s no-personal-tax world and
decreases the spread between debt and equity costs.
4. Thus, some of the advantage of debt financing is lost, so debt financing is less valuable to
firms.

 What does capital structure theory prescribe for corporate managers?

1. MM, No Taxes: Capital structure is irrelevant--no impact on value or WACC.
2. MM, Corporate Taxes: Value increases, so firms should use (almost) 100% debt
financing.
3. Miller, Personal Taxes: Value increases, but less than under MM, so again firms should
use (almost) 100% debt financing.

 Do firms follow the recommendations of capital structure theory?

1. Firms don’t follow MM/Miller to 100% debt. Debt ratios average about 40%.
2. However, debt ratios did increase after MM. Many think debt ratios were too low, and
MM led to changes in financial policies.

 Cost of equity and WACC

1. Just like with MM with taxes, the cost of equity increases with D/V, and the WACC
declines.
2. But since rsL doesn't have the (1-T) factor in it, for a given D/V, rsL is greater than MM
would predict, and WACC is greater than MM would predict.

 What if L's debt is risky?

If L's debt is risky then, by definition, management might default on it. The decision to
make a payment on the debt or to default looks very much like the decision whether to
exercise a call option. So the equity looks like an option.

 Equity as an option
 Suppose the firm has $2 million face value of 1-year zero coupon debt, and the current
value of the firm (debt plus equity) is $4 million.
If the firm pays off the debt when it matures, the equity holders get to keep the firm. If
not, they get nothing because the debtholders foreclose.

 Managerial Incentives
When an investor buys a stock option, the riskiness of the stock () is already
determined. But a manager can change a firm's  by changing the assets the firm invests
in. That means changing  can change the value of the equity, even if it doesn't change
the expected cash flows: So changing  can transfer wealth from bondholders to
stockholders by making the option value of the stock worth more, which makes what is
left, the debt value, worth less.

 Bait and Switch

Managers who know this might tell debtholders they are going to invest in one kind of
asset, and, instead, invest in riskier assets. This is called bait and switch and bondholders
will require higher interest rates for firms that do this, or refuse to do business with them.

 If the debt is risky coupon debt

If the risky debt has coupons, then with each coupon payment management has an option
on an option—if it makes the interest payment then it purchases the right to later make
the principal payment and keep the firm. This is called a compound option.