MM Proposition I & II Without Taxes

MM Proposition I Without Taxes

• Capital Structure Irrelevance: The market value of a company remains unaffected by its capital structure.

• Value of Companies:

  • Levered Company (V): Refers to a company that uses debt in its capital structure.
  • Unlevered Company (VU): A company that is financed purely with equity and has no debt.
  • Key Equation:
    V = V_U
  • This implies that the value of a levered company is equal to the value of an unlevered company.

• Value Determinants:

  • The value of a company is determined solely by its expected future cash flows, without regard to how it finances those cash flows (i.e., use of debt vs. equity).
  • No impact of debt or equity on valuation in a perfect market.

• Cost of Capital:

  • In the absence of taxes, the weighted average cost of capital (WACC) does not change with different capital structures.
  • Financial leverage does not affect WACC due to market efficiencies.

MM Proposition II Without Taxes

• Impact of Financial Leverage on Cost of Equity:

  • As a company increases its debt (financial leverage), the cost of equity capital rises.
  • This is due to the increased risk that equity investors face when a company takes on more debt.

• Cost Comparison:

  • Debt is generally less costly than equity because debtholders have a priority claim on the company’s assets and cash flows.
  • This implies that shareholders demand a higher return when the financial risk increases, resulting in a higher cost of equity.

• Consequence:

  • Higher financial leverage leads to an increase in the required return on equity, compensating for the additional risk taken by equity investors.