Question

1. Explain Modigliani and Miller (M&M) Theory of Capital Structure under three special cases with the equations?

Answer 1

MODIGLIANI AND MILLER THEORY

CASE 1 :

It claims that the company’s capital structure does not impact its value. The value of a company is calculated as the present value of future cash flows, thus, the capital structure does affect it.

Where:

V_U = Value of the unlevered firm (financing through equity)

V_L = Value of the levered firm (financing through mix of debt and equity)

CASE 2 :

It states that the cost of equity of the company is directly proportional to the company’s leverage level. An increase in leverage level implies higher default probability to a company. Therefore, investors tend to demand a higher cost of equity (return) to be compensated for the additional risk.

Where:

r_E = Cost of levered equity

r_a = Cost of unlevered equity

r_D = Cost of debt

D/E = Debt-to-equity ratio

CASE 3 :

It states that tax shields that result from the tax-deductible interest payments make the value of a levered company higher than the value of an unlevered company. Tax-deductible interest payments positively affect a company’s cash flows. Since a company’s value is determined as the present value of the future cash flows, the value of a levered company increases.

Where:

t_c = Tax rate

D = Debt

CASE 4 :

It states that the cost of equity has a directly proportional relationship with the leverage level.

The presence of tax shields affects the relationship by making the cost of equity less sensitive to the leverage level. Although the extra debt still increases the chance of a company’s default, investors are less prone to negatively reacting to the company taking additional leverage, as it creates the tax shields that boost its value.