MM Theory and APV

December 13, 2019

Modigliani and Miller Theory
• Objective to explain real world influences on GEARING
• Simple assumptions:
• No transaction cost
• No risk of bankruptcy
• Perfect capital market
• Investors are indifferent about borrowing themselves or the companies they
invest in
• Cost of debt is constant for all levels of gearing
Conclusion of MM theory (without
tax) Companies in equilibrium
(same size earnings before tax and same risk class)

Keg > Keu

Keg = Keu + (Keu – Kd) D/E

WACC ug = WACC g

MV ug = MV g
Conclusion of MM theory (with tax)
Companies in equilibrium
(same size earnings and same risk class)
Keg > Keu
Keg = Keu + (Keu – Kd) (1-t) D/Eg

WACC ug > WACC g

WACC g = WACCug (1-Dt/(D+E))

MV g > MV ug

MVg = MVug + Dt

MVug = E + D (1-t)

Practice 10, 11
Adjusted Present Value
• The APV method may be used when a business entity is considering
an investment in a project that will have different business risks and
different financial risks from its current operations
• The APV method is an alternative to calculating a new cost of equity
and a new WACC, for example using the Modigliani-Miller formulae or
the asset beta formula.
Amount
Base case NPV XXXX
Plus: PV of tax relief XXXX
Minus: PV of other costs (XXXX)
Adjusted Present Value XXXX
Project specific cost of capital
• If a company plans to invest in a project which involves diversification
into a new business, the investment will involve a different level of
systematic risk from that applying to the company's existing business.
• A discount rate should be calculated which is specific to the project,
and which takes account of both the project's systematic risk and the
company's gearing level. The discount rate can be found using the
CAPM.
Step 1 • Obtain published Beta values for companies in new industry

• Calculate ungeared beta using the above beta value and that particular
Step 2 company’s D:E ratio (whose beta is being used) or industry averages
• Regear the ungeared beta using company’s D:E ratio

Step 3 • Use the regeared beta in CAPM to calculate project specific cost of equity
Practice Q7, Q8
CALCULATION
• BASE CASE NPV (calculated using Keu as if company was all equity)
• Use asset beta Ba of the industry or the new business by converting geared beta Be into Ba
and Keu calculated using CAPM. OR
• You have Keg of an equivalent company. Use MM formula to calculate Keu with Company’s
D:E OR
• Convert WACCg of an equivalent company into WACCu using MM formula
• PV of other Costs Practice Q-12

• Costs such as required for IPO/raising new capital

• Documentation/underwriting cost of debt financing
• If they are tax allowed, PV should include impact of tax relief
• Generally, these are discounted at risk-free rate of return Practice Q-13
• PV of tax shield
• Calculate annual interest cost
• Discounting these using pre-tax discount rate
• If loan is amortising, then Practice Q-14
Arguments in favor of APV
Against MM theory
• The APV method does not rely on assumptions about the new WACC
of the firm if the project is undertaken.
• The APV method allows for the specific tax relief on the borrowing to
finance the project, and does not assume that the debt will be
perpetual debt.
• The APV method allows for other costs, such as the costs of raising
new finance (issue costs).
Practice Q-15