II Capital Structure in a Perfect Market

Propositions by Modigliani-Miller without taxes

▪ The market value of a firm is independent of the debt-equity ratio.

Proposition I
V L =VU  E + D =U

▪ The cost of capital of levered equity are a linear function of the

Proposition II debt-equity ratio

rE = rU + ( rU − rD ) 
D
E
▪ The weighted average cost of capital of a firm are constant and
Proposition III independent of the capital structure

rWACC = rU

Prof. Dr. Oliver Read -1- 72212 ICS

II Capital Structure in a Perfect Market

Proof of Modigliani-Miller without taxes Proposition I

▪ Two almost identical firms except the debt-equity ratio: U unlevered, L levered

▪ Strategy I: Equity participation (percentage x) of the levered firm

Position t=0 t = 1,2,...
Buy percentage of the levered firm –x·E x·(EBITt – rD·D)

▪ Strategy II: Equity participation (percentage x) of the unlevered firm and (private) borrowing
Position t=0 t = 1,2,...
Borrowing of x·D x·D –x·rD·D
Buy percentage of the unlevered firm –x·U x·EBITt
Total x·(D – U) x·(EBITt – rD·D)
▪ The cashflows in t = 1, 2, … are identical, therefore the investment amounts have to be equal based
on the no-arbitrage principle i.e.
x ( D −U ) = −x  E
 x  E + x  D = x U
 E + D =U
 V L =VU

Prof. Dr. Oliver Read -2- 72212 ICS

II Capital Structure in a Perfect Market

Derivation of Modigliani-Miller without taxes Proposition II

▪ Proposition I: U =E+D
Starting point ▪ Cost of equity: EBIT − rD  D
rE =
E
EBIT
rU =  EBIT = rU U
U
▪ Inserting the second equation in the first equation and applying
Solution Proposition I leads to:

rU U − rD  D
rE = Proposition I
E
rU  ( E + D ) − rD  D
=
E
E D D
= rU  + rU  − rD 
E E E
= rU + ( rU − rD ) 
D
E

Prof. Dr. Oliver Read -3- 72212 ICS

II Capital Structure in a Perfect Market

Derivation of Modigliani-Miller without taxes Proposition III

rE = rU + ( rU − rD ) 
▪ Proposition II:
D
Starting point ▪ WACC of the levered firm: E
E D
rWACC =  rE +  rD
E+D E+D
▪ Inserting Proposition II leads to:
Solution Proposition II

E  D
  rU + ( rU − rD )   +
D
rWACC =  rD
E+D  E  E+D

+ ( rU − rD ) 
E D D
= rU  + rD 
E+D E+D E+D
E D
= rU  + rU 
E+D E+D
1
= rU  ( E + D)
E+D
The weighted average cost of capital of a firm are
= rU constant and independent of the capital structure

Prof. Dr. Oliver Read -4- 72212 ICS

III Capital Structure with Market Imperfections

Propositions by Modigliani-Miller with taxes

▪ Mit steigendem Verschuldungsgrad nimmt der Unternehmenswert

Proposition I zu, d.h. der Marktwert eines Unternehmens (als Wert des Gesamt-
kapitals) ist abhängig von seiner Kapitalstruktur
EBIT  (1 −  ) Corporate tax rate
V =U

rU
V L = V U +  D
▪ The cost of capital of levered equity are a linear function of the
Proposition II debt-equity ratio

rE = rU + ( rU − rD )  (1 −  ) 
The leverage effekt is slightly
D reduced
E
▪ Die Gesamtkapitalkosten sind abhängig von der Kapitalstruktur
Proposition III des Unternehmens:
 D 
rWACC = rU  1 −   
 E+D
1

Prof. Dr. Oliver Read -5- 72212 ICS

III Capital Structure with Market Imperfections

Proof of Modigliani-Miller with taxes Proposition I

▪ Strategy I: Equity participation (percentage x) of the levered firm

Position t=0 t = 1,2,...

Buy percentage of the levered firm –x·E x·(EBITt – rD·D)·(1–τ)

▪ Strategy II: Equity participation (percentage x) of the unlevered firm and (private) borrowing
Position t=0 t = 1,2,...
Borrowing of x·D·(1–τ) x·D·(1–τ) –x·rD·D·(1–τ)
Buy percentage of the unlevered firm –x·U x·EBITt ·(1–τ)
Total x·(D·(1–τ) – U) x·(EBITt – rD·D)·(1–τ)

▪ The cashflows in t = 1, 2, … are identical, therefore the investment amounts have to be equal
based on the no-arbitrage principle i.e.
− x  E = x  ( D  (1 −  ) − U )
 E + D  (1 −  ) = U
 E + D −  D = U
VL VU

 V L = V U +  D

Prof. Dr. Oliver Read -6- 72212 ICS

III Capital Structure with Market Imperfections

Derivation of Modigliani-Miller with taxes Proposition II

▪ Proposition I: U = E + (1 −  )  D
(  D )  (1 −  )
Starting point ▪ Cost of equity: EBIT − r
=
D
rE
E
EBIT  (1 −  )
rU =  EBIT  (1 −  ) = rU  U
U

▪ Inserting the second equation in the first equation and applying

Solution Proposition I leads to:
rU  U − rD  D  (1 −  ) Proposition I
rE =
E
rU  ( E + (1 −  )  D ) − rD  D  (1 −  )
=
E
E D D
= rU  + rU  (1 −  )  − rD  (1 −  ) 
E E E
= rU + ( rU − rD )  (1 −  ) 
D
E
Prof. Dr. Oliver Read -7- 72212 ICS
III Capital Structure with Market Imperfections

Derivation of Modigliani-Miller with taxes Proposition III

rE = rU + ( rU − rD )  (1 −  ) 
D
▪ Proposition II: E
Starting point ▪ WACC of the levered firm:
E D
rWACC =  rE +  rD  (1 −  ) Interest tax shield
E+D E+D
▪ Inserting Proposition II leads to:
Solution Proposition II

E  D
  rU + ( rU − rD )  (1 −  )   +
D
rWACC =  rD  (1 −  )
E+D  E  E+D

+ ( rU − rD )  (1 −  ) 
E D D
= rU  + rD  (1 −  ) 
E+D E+D E+D
E D
= rU  + rU  (1 −  ) 
E+D E+D
 E D  D 
= rU   + − 
E+D E+D E+D
 D 
= rU  1 −   
 E+D

Prof. Dr. Oliver Read -8- 72212 ICS