CAPITAL STRUCTURE

(Traditional Theory)
Miller & Modigliani I
 Merton Miller and Franco Modigliani,
1958, The Cost of Capital,
Corporation Finance and the
Theory of Investment, American
Economic Review 48, 261-297.
M & M ASSUMPTIONS:

 HOMOGENOUS RISK CLASS

 Business Risk = s EBIT
 If s A = s B => Firms A and B are in
the same risk class

 HOMOGENOUS EXPECTATIONS
 Investors have identical estimates
of future EBIT
M & M ASSUMPTIONS:

 PERFECT CAPITAL MARKETS

 No Transactions Costs
 All Agents Borrow at the Risk-Free
Rate
(rD = rrf)
 ALL CASH FLOWS ARE
PERPETUITIES
i.e. , V = EBIT(1-t) / r
M & M without Corporate
Taxes:
 Proposition I: Value is established
by capitalizing EBIT at the discount
rate appropriate for the risk class.
 VL = VU = EBIT/Wacc = EBIT/r0
 V is independent of Firm's leverage
and Wacc is:
 independent of capital structure and
 equal to r0
M & M without Corporate
Taxes:
 Proposition II:
 rs = r0 + risk premium
 rs = r0 + (r0 - rD)(D/E)
 Adding debt will not increase V since
benefits of cheaper debt will be
exactly offset by an increase in rs.
(V & WACC are unaffected by Firm's
Structure)
Miller & Modigliani II

  MertonMiller and Franco Modigliani,

1963, Corporate Income Taxes
and the Cost of Capital: A
Correction, American Economic
Review 53, 433-443.
M & M with Corporate Taxes

 Proposition I:

VL = VU + Gain from Leverage

VL = VU + tD
VL = EBIT(1-t)/r0 + tD
M & M with Corporate Taxes

 Proposition II:

rs = r0 + (r0 - rD)(D/S) (1-t)

(rs increases at a slower rate than without taxes)

Miller Model with Personal
Taxes
 Modifies the above to include
personal taxes

 Adds some conceptual issues to the

discussion:
 Personal Taxes for Investors
 Bondholders
 Stockholders
 Firm does not pay these taxes directly
Criticisms of M & M
 Brokerage costs get assumed away
(Arbitrage proof may break down when
these are added back into the
problem)

 Agents borrow at the same rate - rrf

(Firms borrow at D rates)

 Constant tax rate across firms and investors

( D tax rates are observed)
Tradeoff Models

 Evolved to solve some of these issues

 Incorporate Agency Costs and

Distress Costs

 Extend the earlier models as follows:

VL = VU + tD - PV{Distress + Agency
Costs}
Agency Costs

 Risk Shifting

 Monitoring Costs

 Bonding Costs

 Lost Efficiency (Dead Weight Costs)

Direct Costs of Distress

 Lawyer Fees

 Court Costs

 Other Quantifiable Administrative

Costs
Indirect Costs of Distress

 Non-optimal Managerial Actions

 Impact on Firm’s Business

Relationships
 Employees
 Suppliers
 Customers
 Lenders
 Other Investors
Focus on these formulae:

 VL = VU + tD - PV{Distress + Agency
Costs}
or
 VL = EBIT(1-t)/r0 + tD - PV{Distress +
Agency Costs}

If t = D = “distress” = 0, then VL = VU
Focus on these formulae:

 rs = r0 + (r0 - rB)(D/E)(1-t)
 If t = B = 0, then rs = r0

 bL = bU { 1 + (1 - t)(D/E) }
 If t = B = 0, then bL = bU