1.

Write the difference between Modigliani and Miller (M&M) Propositions i and ii
with no taxes Modigliani and Miller (M&M) Propositions i and ii with taxes

Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern
thinking on capital structure. The basic theorem states that, in the absence of taxes, bankruptcy
costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected
by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or
selling debt. It does not matter what the firm's dividend policy is.

The theorem is made up of two propositions which can also be extended to a situation with taxes

Propositions Modigliani-Miller theorem (1958) (without taxes)

Consider two firms which are identical except for their financial structures. Then first (Firm U) is
unleveraged: that is, it is financed by equity only. The other (Firm L) is leveraged: it is financed
partly by equity, and partly by debt.

The Modigliani-Miller theorem states that the value the two firms is the same

Proposition I

here VU is the value of an unlevered firm = price of buying all the firm's equity, and

VL is the value of a levered firm = price of buying all the firm's equity, plus all its debt

To see why this should be true, suppose a capitalist is considering buying one of the two firms U
or L. Instead of purchasing the shares of the leveraged firm L, he could purchase the shares of
firm U and borrow the same amount of money B that firm L does. The eventual returns to either
of these investments would be the same.

Therefore the price of L must be the same as the price of U minus the money borrowed B, which
is the value of L's debt

This discussion also clarifies the role of some of the theorem's assumptions. We have implicitly
assumed that the capitalist's cost of borrowing money is the same as that of the firm, which need
not be true under asymmetric information or in the absence of efficient markets.
Proposition II

rS is the cost of equity

r0 is the cost of capital for an all equity firm

rB is the cost of debt

B / S is the debt-to-equity ratio

This proposition states that the cost of equity is a linear function of the firm´s debt to equity
ratio. A higher debt-to-equity ratio leads to a higher required return on equity, because of the
higher risk involved for equity-holders in a companies with debt. The formula is derived from
the theory of weighted average cost of capital

These propositions are true assuming

-no taxes exist

-no transaction costs exist

-individuals and corporations borrow at the same rates

These results might seem irrelevant (after all, none of the conditions are met in the real world),
but the theorem is still taught and studied because it tells us something very important. That is, if
capital structure matters, it is precisely because one or more of the assumptions is violated. It
tells us where to look for determinants of optimal capital structure and how those factors might
affect optimal capital structure.

Propositions Modigliani-Miller theorem (1963) (with taxes)

The value of a firm is still determined by the firm's assets, which generate cash flows. By levying
taxes, the government joins debt-holders and shareholders to share the cash flows (and thus, the
value) of the firm.

Propositon 1(with taxes)

VL is the value of a levered firm

VU is the value of an unlevered firm

TCB is the tax rate(T_C) x the value of debt (B)

This means that there are advantages for firms to be levered, since corporations can deduct
interest payments. Therefore leverage lowers tax payments. Dividend payments are non-
deductible.

The deductibility of interest expense favours the use of debt financing for companies. Since this
tax shelter accrues to shareholders, using debt will increase the value of the entire equity. The
more the firm borrows, the greater the tax shelter, and thus the higher the share value of the
stock. Therefore, if other MM assumptions hold, firms will maximize debt in their capital
structures: the optimal capital structure in a tax world will be infinitely close to 100% debt!

Proposition II: (with taxes)

The cost of equity of a levered firm is equal to the cost of equity of an unlevered firm plus a risk
premium which depends on both the degree of leverage and the corporate tax rate:

rS is the cost of equity

r0 is the cost of capital for an all equity firm

rB is the cost of debt

B / S is the debt-to-equity ratio

Tc is the tax rate

As debt-equity ratio (thus the financial risk) rises, so does the cost of equity. However, the
weight of equity declines as the firm uses more debt. The reduction in the cost of debt can more
than offset the effect of rising cost of equity. Therefore the cost of capital (WACC) declines as
the firm uses more debt.
The existence of (higher) personal tax rate on interest income than on dividend income, however,
reduces the advantage of debt financing to a company. In the Miller model, debt financing may
add or lower value.

Costs of Financial Distress

More leverage can magnify financial losses, which can put a company into financial distress.
Direct costs are the various costs of filing for bankruptcy, hiring lawyers and accountant, etc.
Indirect costs include higher borrowing costs (Lenders charge higher interest rates to firms in
financial trouble.), a loss of employee morale and productivity, agency costs of debt, etc.
The threat of bankruptcy and the bankruptcy costs discourage firms from pushing their use of
debt to excessive levels.
Firms whose earnings are more volatile, all else equal, face a greater chance of bankruptcy and
should use less debt than more stable firms.

Costs of Financial Distress

More leverage can magnify financial losses, which can put a company into financial distress.
Direct costs are the various costs of filing for bankruptcy, hiring lawyers and accountant, etc.
Indirect costs include higher borrowing costs (Lenders charge higher interest rates to firms in
financial trouble.), a loss of employee morale and productivity, agency costs of debt, etc.
The threat of bankruptcy and the bankruptcy costs discourage firms from pushing their use of
debt to excessive levels.
Firms whose earnings are more volatile, all else equal, face a greater chance of bankruptcy and
should use less debt than more stable firms.

The same relationship as earlier described stating that the cost of equity rises with leverage,
because the risk to equity rises, still holds. The formula however has implications for the
difference with the WACC
Assumptions made in the propositions with taxes are
-Corporations are taxed at the rate T_C, on earnings after interest
-No transaction cost exist
-Individuals and corporations borrow at the same rate
Assumptions of Modigliani and Miller’s proposition
Perfect capital market
Information is freely available and there is no problem of asymmetric information; transactions
are costless; there are no bankruptcy costs; securities are infinitely divisible
Rational investors and managers
Investors rationally choose a combination of risk and return that is most advantageous to them.
Managers act in the interest of the shareholders
Homogenous expectations
Investors hold uniform or identical expectations about future operating earnings
Equivalent risk classes
Companies can be easily classified and grouped into equivalent risk classes on the basis of their
business risk

Absence of tax
It is assumed there is no tax levied by the respective governments on them companies and also in
future there will not be any such tax levies on the companies

2. Write the effect of capital structure on stock price and the cost of capital.

Capital structure refers to the mix of both short- and long-term debt held by the
business, along with the levels of common and preferred equity. The debt will include
any outstanding bond issues, as well as payable items with a duration of a year or more.
Equities will include the retained earnings of the business as well as the common and
preferred shares of stock held as part of the company assets.
Cost of capital refers to the benefits or returns that a business expects to generate from
taking on a specific project, such as building a new manufacturing facility.

This means that the connection between capital structure and cost of capital helps to
demonstrate how decisions on how to operate a business have a direct impact on both the
debt and the equity that the business holds at any given point in time. For example, if a
cost of capital analysis indicates that the returns from building a new plant will not result
in any appreciable increase in revenue generation, the capital structure would be
adversely affected by the increase in debt without some sort of equity growth to offset
that extra expense. As a result, the financial stability of the business is adversely affected
The capital structure discloses the different sources of funding a firm uses in order to
finance its operations and growth. It is usually measured through the gearing ratio: Debt /
(Debt + Equity).

The overall capital structure of a firm varies across the firm’s life and development through
equity or debt issuances. Equity and debt issuance are seen on the balance sheet as an increase on
the liabilities side.

Nonetheless, the balance sheet does not reveal the future decisions regarding the capital
structure of the firm. Indeed, firms’ managers are suspected to hold information that
outside investors and/or the market lack. These information discrepancies between the
 firm (managers) and the market (investors) are known as “asymmetric information”.
Almost all economic transactions involve information asymmetries. These information
failures influence the managers’ financial decision, and influence the market perception
of the firm, through changes in stock price.

Announcement effects
The debt-equity choice conveys information for two reasons:
 Managers will avoid increasing the firm’s leverage if the firm could have financial
difficulties in the future.
 Managers are reluctant to issue equity when the stock is thought to be undervalued.

Stock price reactions to capital structure changes are usually the following:
 Common stock issuance: negative
 Convertible debt issuance: negative
 Straight debt: negative but insignificant
 Bank debt (renewal): positive

Debt issuance
In 1958, Modigliani and Miller stated that in a world without taxes, bankruptcy costs,
agency costs and asymmetric information, and in an efficient market, the value of a firm
is unaffected by how it is financed. In other word, the choice of capital structure is
irrelevant as it does not impact the value of the firm. As a result, debt issuance does not
have any impact on the value of the firm according to their theory.

Nonetheless, the effects of issuing straight debt (a debt which cannot be converted into
something else) is negative but insignificant. But renewing bank debt translates into an
increase in stock prices. Overall, the announcement of a debt issuance has on average
little impact on the stock price, as it shows to the market that the firms :
 Needs funding
 Expects taxable income in the future
 Will pay less tax as it will benefit from a higher tax shield
 Is financially stable enough to convince banks or investors to lend it money

Security sales
The table below (from Grinblatt and Titman (2002) summarizes a number of event
studies that examine stock price reaction to the announcements of new security issues. It
shows that raising capital is considered as a negative signal.
 This is explained by the “adverse selection theory”, which states that firms are reluctant
to issue common equity when the stock is undervalued. Thus, the market often assumes
than common equity issuance and overvaluation go hand in hand. The issuing of common
equity will thus have a negative effect on stock prices, as the market will think the stock
is overvalued. As convertible bonds have a strong equity-like component, Grinblatt and
Titman (2002) argue that the “adverse selection theory” can also explain why the market
usually reacts negatively to the issuance of convertib le bonds.\

Pecking order theory

The market reacts favorably to leverage increase and unfavorably to leverage decrease.
As a result, firms will use either internal financing (inside equity) or debt to finance their
project over outside equity (equity issuance). This is called the “pecking order theory” of
capital structure.
The theory of the financial pecking order states that, of the three possible forms of
financing for a firm (internal cash flow, debt, equity), a firm will prefer to finance itself
from internal cash flow, then debt, and finally, in the last case, by selling equity. This has
a practical consequence on the way the company operates: once it has emptied its internal
cash flow, it will issue debt. If it can no longer generate debt, it will issue equity.
Myers and Majluf (1984) highlight the consequences of information asymmetry between
managers and investors. If the company finances itself with shares, it is because it
believes that shares are overvalued and can therefore provide easy and abundant
financing. If the company finances itself with debt, it is because it believes that shares are
undervalued.
Nonetheless, firms can prefer to resort to equity rather than debt when they are
experiencing financial difficulties. Indeed, in case of financial distress, the risk of having
to suffer financial distress costs can be greater than the cost of issuing equity.
Furthermore, firms can also decide to issue preferred equity in difficult times rather than
common equity. In effect, preferred shareholders cannot force a firm into bankruptcy
when it fails to meet its dividend obligations (while common shareholders can).

3. Discuss the difference between pecking order theory, trade -off theory and signaling
theory.

Trade-off theory: In contrast to dividends, interest paid on debt reduces the firm’s
taxable income. Debt also increases the probability of bankruptcy. Trade-off theory
suggests that capital structure reflects a trade-off between the tax benefits of debt and the
expected costs of bankruptcy (Kraus and Litzenberger, 1973).
Expected Bankruptcy Costs and Debt: If k is higher in Equation 2, the equilibrium level
of D should be lower. As the expected bankruptcy costs increase, the advantages of using
equity also increase. This result has several interpretations. Large firms should have more
debt because they are more diversified and have lower default risk. Tangible assets suffer
a smaller loss of value when firms go into distress. Hence, firms with more tangible
assets, such as airplane manufacturers, should have higher leverage compared to those
that have more intangible assets, such as research firms. Growth firms tend to lose more
of their value than non-growth firms when they go into distress. Thus, theory predicts a
negative relationship between leverage and growth. Empirical evidence by Rajan and
Zingales (1995), and Frank and Goyal (2003) generally support the above predictions.

Taxes and Debt: When T increases in Equation 2, debt should also increase because
higher taxes lead to a greater tax advantage of using debt. Hence, firms with higher tax
rates should have higher debt ratios compared to firms with lower tax rates. Inversely,
firms that have substantial non-debt tax shields such as depreciation should be less likely
to use debt than firms that do not have these tax shields. If tax rates increase over time,
debt ratios should also increase. Debt ratios in countries where debt has a much larger tax
benefit should be higher than debt ratios in countries whose debt has a lower tax benefit.
Debt and Profitability: As suggested in Equation 2, if increases, D should also
increase. Thus, more profitable firms should have more debt. Expected bankruptcy costs
are lower and interest tax shields are more valuable for profitable firms.

Debt Conservatism: Although trade-off theory predicts that the marginal tax benefit of
debt should be equal to the marginal expected bankruptcy cost, the empirical evidence is
mixed. Some researchers argue that the former is greater than the latter because direct
bankruptcy costs are small and the level of debt is below optimal (Graham, 2000)

Target Debt Level: Debt changes should be dictated by the difference between current
level and the level of debt predicted by Equation 2. In the recent literature, the continuous
process of adjusting capital structure toward the target ratio has been called “target
reversion” or “mean reversion” (Shyam-Sunder and Myers, 1999; Frank and Goyal,
2003)

Asymmetric information theories of capital structure: The key element of these theories
is asymmetric information between firm’s insiders and outsiders. Information
asymmetries exist in almost every facet of corporate finance and complicate managers’
ability to maximize firm values. Managers of good quality firms face the challenge of
directly convincing investors about the true quality of their firm especially if this
concerns future performance. As a result, investors try to incorporate indirect evidence in
their valuation of firm performance by analyzing information-revealing actions including
capital structure choice.

Pecking-order theory: Myers and Majluf (1984) set forth pecking order theory. Equity is
dominated by internal funds in pecking order theory. Low-quality firms use equity as
much as internal funds but high quality firms prefer internal funds because shares issued
by the company can only be sold with discount (i.e. below their true value) because of
imperfect information problems. Similarly debt dominates equity. Debt suffers from miss
valuation less than equity. The same holds if the firm has available assets-in-place. Hence
a "pecking order" emerges: internal funds, debt, and equity (Myers and Majluf, 1984).
The empirical evidence on pecking order theory is mixed. Shyam-Sunder and Myers
(1999), Lemmon and Zender (2008), and a survey of New York Stock Exchange firms by
Kamath (1997) find support for pecking order while Chirinko and Singha (2000) and
Leary and Roberts (2010) do not. Frank and Goyal (2003) show that the greatest support
for pecking order occurs among large firms. The announcement of issuing stock drives
down the stock price. Empirically, the announcements of equity issues result in
significant negative stock price reactions (Masulis and Korwar, 1986; Antweiler and
Frank, 2006). Good-quality firms tend to use internal funds for financing as much as
possible. Because low-quality firms do not have as much profits and retained earnings as
high-quality firms, they use external sources, usually debt, more frequently. This helps to
explain the described above puzzle about the negative correlation between debt and
profitability.

Pecking order theory predicts that a higher extent of asymmetric information reduces
the incentive to issue equity. The evidence, however, is ambiguous. D’Mello and Ferris
(2000) and Bharath, Pasquariello, and Wu (2008) support the prediction that pecking
order theory is more likely to hold when the extent of asymmetric information is large.
Choe, Masulis, and Nanda (1993) find that equity issues are more frequent when the
economy is doing well and information asymmetry is low. Yet, Frank and Goyal (2003)
find the greatest support for pecking order theory among large firms that are expected to
face the least severe adverse selection problems because they receive better coverage by
equity analysts.
The pecking-order theory starts with asymmetric information—a fancy term indicating
that managers know more about their companies’ prospects, risks, and values than do
outside investors.
Managers obviously know more than investors. We can prove that by observing stock
price changes caused by announcements by managers. For example, when a company
announces an increased regular dividend, stock price typically rises, because investors
interpret the increase as a sign of management’s confidence in future earnings. In other
words,
the dividend increase transfers information from managers to investors. This can happen
only if managers know more in the first place.
Asymmetric information affects the choice between internal and external financing and
between new issues of debt and equity securities. This leads to a pecking order, in which
investment is financed first with internal funds, reinvested earnings primarily; then by
new
issues of debt; and finally with new issues of equity. New equity issues are a last resort
when
the company runs out of debt capacity, that is, when the threat of costs of financial
distress
brings regular insomnia to existing creditors and to the financial manager.
We will take a closer look at the pecking order in a moment. First, you must appreciate
how asymmetric information can force the financial manager to issue debt rather than
common stock.
 The Trade-off Theory vs. the Pecking-Order Theory—Some Recent Tests
In 1995 Rajan and Zingales published a study of debt versus equity choices by large
firms
in Canada, France, Germany, Italy, Japan, the U.K., and the U.S. Rajan and Zingales
found
that the debt ratios of individual companies seemed to depend on four main factors:31
1. Size. Large firms tend to have higher debt ratios.
2. Tangible assets. Firms with high ratios of fixed assets to total assets have higher debt
ratios.
3. Profitability. More profitable firms have lower debt ratios.
4. Market to book. Firms with higher ratios of market-to-book value have lower debt
ratios.

These results convey good news for both the trade-off and pecking-order theories.
Tradeoff enthusiasts note that large companies with tangible assets are less exposed to
costs of financial distress and would be expected to borrow more. They interpret the
market-to book ratio as a measure of growth opportunities and argue that growth
companies could face high costs of financial distress and would be expected to borrow
less. Pecking-order advocates stress the importance of profitability, arguing that
profitable firms use less debt because they can rely on internal financing. They interpret
the market-to-book ratio as just another measure of profitability.

Signaling: In the pecking order model, good quality firms have to use internal funds to avoid
adverse
selection problems and losing value. These firms cannot signal their quality by changing their
capital
structure. In signaling theory capital structure serves as a signal of private information (Ross,
1977). The
main prediction of this theory is that the market reaction on debt issues (more generally, on
leverage increasing transactions such as issuing convertible debt, repurchasing shares, and debt
for equity swaps) is positive. Similarly, the market reaction on equity issues (or leverage-
decreasing transactions) is negative. Leland and Pyle (1977) obtain the same results by using
managerial risk-aversion instead of a bankruptcy penalty. A negative share price reaction on the
announcement of equity issues is usually consistent with empirical evidence, as discussed in the
previous section (similar for leverage-decreasing transactions). Evidence on the positive market
reaction on leverage-increasing transactions (with the exception of debt issues) also supports
signaling theory (Masulis, 1980; Antweiler and Frank, 2006; Baker, Powell, and Veit, (2003).
The evidence on the announcement of debt issues does not support signaling theories. Eckbo
(1986) as well as Antweiler and Frank (2006) find insignificant changes in stock prices in
response to straight corporate debt issues. If a separating equilibrium exists, high-quality firms
issue debt and low-quality firms issue equity. The empirical prediction is that firm value (or
profitability) and the debt-to-equity ratio is positively related. The evidence, however, is
ambiguous. Most empirical studies report a negative relationship between leverage and
profitability as discussed earlier. In a similar spirit, some studies document the superior absolute
performance of equity-issuing firms before and immediately after the issue (Jain and Kini, 1994;
Loughran and Ritter, 1997). Several studies examine long-term firm performance following
capital structure changes. Shah (1994) reports that business risk falls after leverage-increasing
exchange offers but rises after leverage-decreasing exchange offers. Jain and Kini (1994),
Mikkelson, Partch, and Shah (1997), and Loughran and Ritter (1997) document the long-run
operating underperformance of equity issuing firms.

4. List and discuss the factors that influence capital structure decisions.

Frank and Goyal (2009) identify six factors to be driving forces behind capital
structure decision. They call these factors “the core model of leverage.”
1. Firms with high growth opportunities tend to have low levels of leverage.
2. Firms with considerable tangible assets tend to have high levels of leverage.
3. Large firms tend to have high levels of leverage.
4. Profitable firms tend to have less leverage.
5. When expected inflation is high, firms tend to have high levels of leverage.
6. Firms that belong to industries in which the median leverage ratio is high
tend to have higher leverage.

5. Using debt financing is important to constrain managers (to reduce agency cost).
HOW?

In a modern corporation where ownership is separated from management, many benefits are
viewed primarily through an increasing efficiency. The issue of the separation of ownership and
management is related to potential conflict between principals (stakeholders) and agents
(managers). Theoretically possible solution to the agency problem is defined through
the agency theory. The most significant problem are agency costs. Agency costs do not have a
directly quantifiable value.

Jensen and Meckling have shaped the ownership theory of corporation to define the effect
of debt and share capital on agency costs. The option of optimal capital structure is the possible
solution for reducing agency costs. The theory defines that ratio of debt and assets decrease
agency costs and increase the company value through the motivation of management to align
their interest with the principal’s interest. Florackis and Ozkan argue that the principal-agent
problem is related to cash flow and asymmetric information. Debt financing decreases the
agency problem and reduces agency costs. Debt financing results with signals which reduce
asymmetric information between agent and principal and information costs.