Question

Recently you have been invited to the Directors meeting to decide on the future capital structure for the firm. One of your colleagues came with the following argument: “As the firm borrows more and debt becomes risky, both stockholders and bondholders demand higher rates of return. Thus, by reducing the debt ratio we can reduce both the cost of debt and the cost of equity, making everybody better off.”

Using the argument of M&M Proposition I “The market value of a company is independent of its

capital structure”, suggest why this argument is not relevant, for simplicity ignore the tax implications.

Answer 1

Modigliani & Miller Proposition 1 states that company's capital structure does not impact its value in a perfect market without tax considerations.

ie Value of unlevered firm= Value of Levered firm

This is applicable only under the below assumptions

• No taxes
• Securities transaction cost is nil
• Symmetry of information is present
• Cost of borrowing is same for investor and company

Under this assumptions the value of the company is determined only by the future cashflows that the company can offer and not influenced by its capital structure. ie: if a firm has Debt and Equity in its capital structure, there is no benefit/loss for the investors since tax is considered zero. So Debt in any way wont affect the companys stock price. (no variation in stock price even if company's capital structure changes). ie cost of equity

If a firm borrows, there is not tax benefit from interest payments and changes to its capital structure. So debt does not influence a company's stock price,and the capital structure is therefore irrelevant to a company's stock price. Since the firm does notbecome riskier by borrowing funds the bondholders and shareholders do not require a higher ratio to compensate the increase of the risk. No change in cost of equity and no change in cost of debt due to the change in capital structure.

Hence we can say that companys value depend only on the future cash flows it can offer.

PS: This is valid only if M&M 1 assumptions hold true.