Question

Discuss how leverage impacts the cost of capital, taxes, firm value, and risks. Explain why most investors demand that companies have a reasonable amount of leverage. Define and discuss the pros and cons of using the MM proposition.

Answer 1

MM theory is about the effects a firm's capital structure may have on generating returns for investors or equity holders. The definition states that ''the market value of a company is calculated using its earning power and the risk of its underlying assets and that its value is independent of the way it finances investments or distributes dividends.''

The market value of a firm helps in understanding the market capitalization, which further helps determine the overall market share of the firm.

The formulaformula to calculate the market value is to multiply the firm's number of shares outstanding by the current stock price.

MM theory, however, indicates that from the equity holder's point of view, the value of a levered firm (with debt) and an unlevered firm (without debt) should be equal under certain assumptions. These assumptions are as follows:

1. No taxes
2. No transaction costs
3. Equivalence in borrowing costs for both companies and investors
4. Symmetry of market information

Miller and Modigliani theory mentions two propositions. Proposition I states that the market value of any firm is independent of the amount of debt or equity in capital structure.

Proposition II states that the cost of equity is directly related and incremental to the percentage of debt in capital structure.

As a treasury or finance executive, it's important to note the impact of taxes on Proposition I and II and the benefits within. For understanding the propositions better let us proceed with two firms in the garments business:

Firm X, a levered firm (with debt in capital), and Firm Y, an unlevered firm (with no debt in the capital).