Capital Structure I: Modigliani and Miller Propositions

What is the definition for capital structure?

It is the combination of debt and equity capital a firm uses to finance its long-term operations.

What is the optimal mix of financing?

The capital structure where the cost of capital is minimised so that the firm’s value can be maximised.

Explain Miller and Modigliani’s 1958 theory.

In perfect markets a firm’s capital structure should not affect its value.

What are the basic assumptions for M&M’s 1958 theory?

• No taxes

• no transaction costs

• no agency costs

• no information asymmetry

What did M&M’s 1958 theory say about capital structure?

Investment decisions are not changed by financing decisions, e.g. the capital structure of how much debt or equity a company has.

CAPITAL STRUCTURE DOES NOT AFFECT VALUE

What is M&M’s 1963 theory?

M&M put forward an updated version of the theory when it is extended to include taxes and risky debt.

Why is debt financing valuable?

When we borrow debt we must pay interest.

Interest is tax deductible so this tax shield makes the cost of debt cheaper than equity and therefore more valuable.

How do investors view capital structure decisions?

As some sort of signal

If capital structure does matter what must it stem from?

A market imperfection.

• One such imperfection is taxes

• Corporations and investors must pay taxes on the income they earn from their investments

• A firm can enhance its value by using leverage to minimise tax

If a company takes on more debt in the capital structure how does this affect WACC?

It may reduce WACC

• Interest payments are tax deductible thereby creating a tax shield

What happens to the financial risk of a company as debt levels rise?

The financial risk increases

• Creditors may start demanding higher returns to compensate for increased risk

What does over leveraging increase the probability of?

Financial distress, which brings direct costs and indirect costs

• E.g. legal and reconstructuring fees and damaged reputation, strained supplier relationships and reduced employee morale)

What is the M&M theory often misinterpreted as?

As suggesting capital structure is irrelevant

• Instead it provides a foundational framework emphasising that under idealised assumptions changing capital structure alone does not create value.

• However, recognising real world frictions,later theories demonstrate that companies can add value by optimising their debt to equity ratios.