Question

Provide a detailed explanation and discussion of Modigliani and Miller’s Proposition I and II

Answer 1

The Modigliani - Miller theorem states that the value of the firm is irrelevant of its capital structure.

Capital structure implies how a company finances its assets. It indicates whether a company finances through only debt, or only equity or through different combinations of both debt and equity.

Thus, the theorem says that

the way a company finances itself, either by using high debt (levered firm) or with equity only (unlevered firm) or combination of both options; does not effect the market value of a firm.

So, this theorem is also called as Irrelevance theory.

There are two cases

-Proposition I and II with no taxes

-Proposition I and II with taxes

PROPOSITION I AND II WITH NO TAXES

It is based on following assumptions:

· No taxes

· No transaction cost between buyers and sellers

· Symmetry of information. That means investor will have same information that a corporation has.

· Cost of borrowing is same for investors and corporations

· No floatation cost such as an underwriting commission, payment to merchant bankers, advertisement expenses, etc.

· No corporate dividend tax

In case where all the above assumptions holds true, the theory is divided into

Proposition I

This proposition states that VU = VL

VU = Value of the unlevered firm (financing only through equity)

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

The market value of levered firm is same as unlevered firm, if all the above assumptions are true.

Propostion II

This proposition states that the company’s cost of equity is directly proportional to the company’s leverage level.

It is given by

rE = rU + (D/E)*( rU - rD)

here,

rE = Cost of levered equity

rU= Cost of unlevered equity

rD = Cost of debt

D/E = Debt-to-equity ratio

PROPOSITION I AND II WITH NO TAXES

In real world, it is not possible that the assumptions hold true.

So, the propositions in real world changes as below

Proposition I

This proposition states that VL = VU + t *D

t= tax rate

D= debt

This proposition states that value of levered company is greater than the value of an unlevered company as levered company includes tax shields that result from the tax-deductible interest payments

Proposition II

It is given by

rE = rU + [(D/E)* (1-t)*( rU - rD)]

This proposition states that the cost of equity has a directly proportional relationship with the leverage level. But, here the presence of tax shields affects the relationship by making the cost of equity less sensitive to the leverage value.