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.
In the MM no-tax world, the value of a company (size of a pie)
depends not on how it is sliced (the capital structure), but rather MM Proposition I (With Taxes): Value Is Maximized at 100% Debt Tax
on the size of the pie pan (the firm’s asset base). shield provided by debt. But under the tax code of most countries, interest
payments are a pretax expense and are therefore tax deductible, while
dividends are paid on an after-tax basis. The differential tax treatment
encourages firms to use debt financing because debt provides a tax shield
that adds to the value of the company.

EBIT belongs to providers of capital; if no debt, all EBIT belongs to equity
holders, and the value of the company is the discounted PV of these earnings. If we maintain MM’s other
assumptions (i.e., no cost of
Value of the company with leverage = value of the company without bankruptcy), the value of the
leverage: V = V U company increases with increasing
L
levels of debt, and the optimal
where: V = value of levered firm; V = value of unlevered firm capital structure is 100% debt.
L
U
Investor can have homemade leverage by substituting his own leverage
(in addition to owning stock) for company’s leverage.
MM II supports MM1: Because the benefits of lower cost debt are offset by
As this process is assumed to be costless, a company’s capital structure the increased cost of equity, the relative amount of debt versus equity in the
is irrelevant in the presence of perfect capital markets. firm’s capital structure does not affect the overall value of the firm.