Twinkle Gismondi, Valdemar Frost & Adnan Rajin

ASSIGNMENT- Group 14
PART 1
In 1958 two economists, Franco Modigliani and Merton Miller, developed one of the most relevant
and important theorems in corporate finance.
The main idea of the whole M&M theory revolves around the statement that despite all factors,
capital structure does not affect the company’s enterprise value, which is primarily affected by the
firm's future cash flows.
The original proposition of the theorem assumed an efficient market, with no taxes, no transaction
costs, no bankruptcy costs, and symmetric information.
Later, in 1963, the two authors added the effect of taxes in their model, to make it closer to reality.

M&M’s theorem is based on three main propositions:

The first proposition without taxes states that the value of an unleveraged firm is equal to the value
of a leveraged firm.
The reason is that the value of a company can be calculated as the present value of future cash flow
and the capital structure does not affect it. In this proposition we assume that the firm does not
pay any taxes, therefore if the company has a leveraged capital structure, it does not obtain any
benefit from having debt. In terms of financial leverage, more leverage increases risk and returns,
thus gains and losses are amplified but the value of equity stays constant. We can express the latter
concept with the following formula:

𝑉𝐿 = 𝑉𝑈

𝑉𝐿 = 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒𝑑 𝑓𝑖𝑟𝑚, 𝑉𝑈 = 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑎𝑔𝑒𝑑 𝑓𝑖𝑟𝑚

Now, let’s consider the proposition while also considering the tax effect. The equation will change by
adding 𝑡𝑐 ⋅ 𝐷, where 𝑡𝑐 is the tax rate and D is the debt. By adding these two elements we are saying
that there is a creation of a tax shield from the tax-deductible interest payments.

Thus, the formula changes to:

𝑉𝐿 = 𝑉𝑈 + 𝑡𝑐 ⋅ 𝐷

The second proposition states that the cost of equity increases as the debt-equity ratio increases. So,
if you increase borrowing to get a cheaper rate, you will also increase the amount of equity you need
to pay. Without considering the effect of taxes, the financial structure does not matter, the expected
return on equity is balanced by a cheaper debt, and because of that the WACC remains constant.
However, if we consider the effect of the taxes, a firm can benefit from the increment of debt in
their capital structure due to the advantage of using a tax shield, thus the firm’s WACC will
decrease while the value will rise.

The last proposition of the irrelevance of the dividend policy, in a perfect market, the value of a firm
remains unbothered by its dividend policy.

Conclusion
These propositions were highly criticized by economic experts due to the unrealistic assumptions,
however, the M&M theorem is the main consensus in corporate finance since they proposed some
of the fundamentals for other fundamental theories in the field of financial structure.
Twinkle Gismondi, Valdemar Frost & Adnan Rajin

PART 2
Discuss the difference between the debt overhang and the asset-substitution problem.

Debt overhang is a problem that can occur when the managers of a firm act in the best interest of
the equity holders. This can be an issue since a leveraged company is a mixture of creditors and
equity holders. Thus, in some situations, managers of a firm can reject projects which have a
positive NPV for the firm, since it has a negative NPV for the equity holders, and vice versa.

Given the example from class.

An investment opportunity with a guaranteed return of 30 in period 1, with a cost of 20 in period 0.

FIRM VALUE DEBT HOLDERS EQUITY HOLDERS

0,5 GOOD STATE 200 > 230 100 > 100 100 > 130

0,5 BAD STATE 40 > 70 40 > 70 0>0

AVERAGE 140 > 150 70 > 85 50 > 65

In this situation the managers, which act on the behalf of equity holders, will not partake in the
investment opportunity with positive NPV. This occurs due to the firm having a sufficiently large
amount of debt. Thus, causing the debt holders to receive a larger part of the expected return of the
investment opportunity, thus reducing the amount of expected return that the equity holders
receive. In the example the investment opportunity gives a guaranteed return of 30 with a cost of
20. But due to the firm having a sufficiently large amount of debt, the expected return for the
equity holders is only 15. Resulting in the managers rejecting 𝑵𝑷𝑽𝒇𝒊𝒓𝒎 = 𝟏𝟎 for the firm since the
𝑵𝑷𝑽𝒆𝒒𝒖𝒊𝒕𝒚 𝒉𝒐𝒍𝒅𝒆𝒓𝒔 = −𝟓.

Another way highly leveraged firms affect manager decisions are through asset substitution in which
firms partake in highly risky investments. This occurs since equity holders' expected return needs to
cover the expected return that the debt holders receive when a firm partakes in a new investment
opportunity. Which usually is a negative NPV for the firm but positive NPV for the equity holders.
Twinkle Gismondi, Valdemar Frost & Adnan Rajin

Graph taken from slides in lecture 2.

The relationship in the asset substitution scenario is quite like options in which the more volatile the
asset the higher the price of the option. In which the equity holders are in some way buying call
options and the debt holders are selling put options. Thus, equity holders receive great returns if
they can partake in a risky venture and receive low or even negative expected returns if they
partake in smaller investment projects.

How are these concepts related to the Modigliani-Miller theory (max. 200 words)?
Highlight the three most important sentences in bold.

The concepts of debt overhang and asset substitution is related to the second proposition of M&M,
which states that the cost of equity is increased as the debt-to-equity ratio increases. When the firm
is highly leveraged the equity holders expect a higher rate of return since the firm is acquiring
more risk, which is further reassured by the CAPM theory.

Dividend policy can affect the rate of which the managers accept and reject positive NPV projects,
when the firm pays dividends the equity holders are incentivized to reject internally financed
positive NPV investments. Which is related to the third proposition of M&M it however rejects the
proposition since the firm is affected by the dividend policy.