Wk8 Concise Notes on Capital Structure and Modigliani & Miller Propositions

Corporate Capital Structure

Corporate capital structure refers to the mix of debt and equity financing a corporation employs. The leverage, or financial gearing, is vital as it influences financial risk and return. Key questions regarding capital structure include whether there is an ideal balance of debt and equity that maximizes the firm's market value.

Value of the Firm

The value of a firm (V) is derived from the sum of its debt (D) and equity (E), expressed as: V = D + E . This relationship also leads to the debt-equity ratio, defined as D/E , indicating the extent of financial leverage used by the firm. A firm with no debt is termed unlevered, while one with debt is called levered.

Modigliani & Miller Proposition I

Under the Modigliani & Miller Proposition I (MM Proposition I), in perfect markets (where there are no taxes, bankruptcy costs, or asymmetrical information), the capital structure is irrelevant to the firm's overall value. The total value of a firm remains constant regardless of how it is financed; it is determined solely by its real assets. This principle states that: VL = VU , meaning the value of a levered firm (VL) equals the value of an unlevered firm (VU) in perfect conditions.

Assumptions of MM Proposition I

• No taxes or transaction costs

• No bankruptcy costs

• All firms share the same risk profile

• Individuals and corporations can borrow at the same risk-free interest rate

• Perfect and frictionless capital markets

Implications of MM Proposition I

Investors can create their own leverage (home-made leverage) by borrowing to invest in unlevered firms akin to those firms with leverage. Consequently, the decision on capital structure does not impact the firm’s value since the expected returns on the same risk class of securities should align irrespective of leverage.

MM Proposition II

MM Proposition II elaborates how the required rate of return on equity (rE) increases with the proportion of debt in a firm's capital structure. This increase follows the formula: rE = rA + \frac{D}{E} (rA - rD) , where:

• rA = expected return on assets

• rD = expected return on debt

• D/E = debt-to-equity ratio

This implies that while leverage raises the firm's financial risk, the firm's overall cost of capital remains unchanged due to the compensatory nature of the returns demanded by equity holders.

Conclusion

The MM propositions indicate that in an idealized environment, the choice between debt and equity financing does not alter firm value, despite leverage's impact on expected returns and risk profiles. Understanding these principles is crucial in corporate finance as they form the theoretical backbone for debt and equity financing decisions.