Page 17 - FINAL CFA II SLIDES JUNE 2019 DAY 6

LOS 21.a: Explain the Modigliani–Miller propositions regarding capital READING 21: CAPITAL STRUCTURE
structure, including the effects of leverage, taxes, financial distress,
agency costs, and asymmetric information on a company’s cost of
equity, cost of capital, and optimal capital structure.
MODULE 21.1: THEORIES OF CAPITAL STRUCTURE

MM Proposition I (No Taxes): The Capital Structure Irrelevance Proposition
Value of a firm is unaffected by its capital structure.

(Restrictive) Assumptions:
• Capital markets are perfectly competitive: there are no transactions costs, taxes, or bankruptcy costs.
• Investors have homogeneous expectations: they have the same expectations with respect to cash flows generated by the firm.
• Riskless borrowing and lending: investors can borrow/lend at the risk-free rate.
• No agency costs: no conflict of interest between managers and shareholders.
• Investment decisions are unaffected by financing decisions: operating income is independent of how assets are financed.
Value of a company (size of a pie) depends not on how it is sliced (capital
structure), but rather on the size of the pie pan (the firm’s asset base). MM Proposition I (With Taxes): Value Is Maximized at 100% Debt. Firms
use debt financing as it provides a tax shield that adds to the value of the
company.

On same assumptions, value
of the company increases
with increasing levels of debt,
and the optimal capital
Company value (with leverage) = company value (without): V = V U structure is 100% debt.
L

Investor can have ‘homemade’ leverage by substituting equity for debt!

As this process costless, capital structure is irrelevant!

MM I (without tax) supports MM1 (without tax): Because the benefits of
lower cost debt are again offset by the increased cost of equity!