Question

Please describe the optimal capital structure (D/E ratio) based on following different assumptions, and also describe the change of cost of equity, cost of debt and WACC when the firm changes its capital structure under three different assumptions as follows. (Please use both figure and writing to answer the questions)

(1) Modigliani & Miller (MM) world (perfect capital market)

(2) Modigliani & Miller Theory (perfect capital market) with corporate tax as the only market imperfection

(3) Modigliani & Miller Theory (perfect capital market) with corporate tax and bankruptcy costs

Answer 1

Modigliani & Miller GAVE CERTAIN ASSUMPTION UNDER PROPOSITION-1 CAPITAL STRUCTURE IRRELEVANCE THEORY

1) INVESTOR EXPECTATION ARE HOMOGENOUS ALL INVESTOR HAVE SAME EXPECTATION

2) BONDS AND SHARES ARE TRADED IN PERFECT CAPITAL MARKET MEANS NO COST INVOLVED LIKE TAXES, TRANSACTION COST

3)INVESTOR CAN BORROW AND LEND AT RISK-FREE RATE

4) NO AGENCY COST

5) OPERATING INCOME UNAFFECTED BY CHANGES IN CAPITAL STRUCTURE

IN MM PROPOSITION 1 THEY SAID MARKET VALUE OF COMPANY NOT AFFECTED BY CAPITAL STRUCTURE THAT IS VALUE LEVERED= VALUE UNLEVERD.IN PERFECT MARKET INVESTOR CAN BUILD THERE OWN LEVERAGETHEREFORE COMPANY CAPITAL STRUCTURE IS IRRELEVANT

PROPOSITION -2 WITHOUT TAXES

COST OF EQUITY IS LINEAR FUNCTION OF DEBT/EQUITY RATIO

DEBT HOLDERS HAVE PRIOR CLAIMS AND NO FINANCIAL DISTRESS COST COST OF DEBT IS LESS THAN COST OF EQUITY

RE=RO+(RO-RD)*D/E

RO=WHEN FINANCED COMPLETELY BY EQUITY

RE=COST OF EQUITY

V=EBIT/RWACC

WITH TAXES-MM SHOWED THAT IN PRESENCE OF TAXES SHOWED VALUE OF LEVERED COMPANY IS GREATER THAN UNLEVERD COMPANY

V LEVERED=VALUE UNLEVERD+TAX*DEBT(TD=DEBT SHIELD)

PROPOSITION -2 WITH TAXES

RE=RO+(RO-RD)*(1-T)*D/E

V=EBIT(1-T)/RWACC
EXTRA DEBT 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.

LEVERAGE MAGINIFIES RISK AND REWARDS. IT OUT FINANCIAL DISTRESS IN BAD TIMES ADD EXPLICIT AND IMPLICIT COST LIKE BANKRUPTCY, AGENCY COST

VLEVERD FIRM=VALUE OF UNLEVERD FIRM +TD(TAX SHIELD)-PRESENT VALUE OF FINANCIAL DISTRESS

AS THE DEBT INCREASE BELOW THE OPTIMAL LEVEL AND FINANCIAL DISTRESS DOMINATES AND REDUCES BENEFIT OF TAX SHIELD SO IT IS BALANCING FINANCIAL DISTRESS AND TAX SHIELD