Modigliani and Miller

What was their main point

• with no corporation tax there is no advantage for firms to issue debt (due to no tax relief)

• the implication is that the WACC is constant no matter what the gearing level - no optimal gear

WACC is constant no matter what the gearing level

• benefits of cheap debt finance are exactly offset by the increased returns required by unvestros for the extra financial risk

So the cost of equity

rises in direct proportion to the increased gearing

they then developed their theory…in the presence of corporation tax

• it is advantageous for firms to gear up

• they pay less tax - interest is allowable

developed theory WACC

• WACC falls as gearing rises

as a result of this tax shield

• geared companies will have more cash to pay out to investorts ans therefore are worth more

So according to the second version of M&M the ideal level of gearing is

nearly 100%

limitations in the real world

• assumes perfect capital markets

• bankruptcy risk

• loan covenants

• tax exhaustion

Assumes perfects capital markets

• a firm will always be able to raise funds for worthwhile projects

• there are no transaction costs

• ignores the increasing danger that high levels of gearing can lead to financial distress costs and agency problems (bankruptcy risk)

Bankruptcy risk

• as firms take on higher levels of gearing the chances of default on debt repayments and hence liquidation increase

• both debt and equity investors will require higher rates of return from highly geared companies

  • this will drive down the prices of their securities

• Indirect financial distress costs - higher supplier costs, sale of investory for below market value

• Agency problem

  • directors may be unwilling to gear the company up to a high level

Loan covenants

• most loan agreements contain restrictive covenants for protection of the lender

• leading to additional costs of borrowing

Tax exhaustion

• at a certain level of gearinng there is no taxable income left to offset income charges

practical aspects which affect gearing

• business risk

• tax exhaustion

• asset quality (tangibles canbe securities against loans)

• access to debt finance

• issue costs

• tax rates

signalling

• raising debt read as a sign of confidence by investors

clientele effect

• the shareholders’ opinions on gearing levels need to be taken into account