irrelevency thory (first paper) Flashcards
(16 cards)
What is the main idea behind the Modigliani-Miller Capital Structure Irrelevance Proposition?
The capital structure irrelevance proposition states that, in a world without taxes, bankruptcy costs, or asymmetric information, the firm’s value is unaffected by its choice of debt or equity financing.
What key assumptions does the Modigliani-Miller model make about capital markets?
The key assumptions include:
No taxes
No bankruptcy costs
Perfect competition
No transaction costs or information asymmetry
Investors can borrow and lend at the same risk-free rate
How do taxes affect the Modigliani-Miller proposition?
In the presence of taxes, the Modigliani-Miller theory suggests that debt financing provides a tax shield because interest payments are tax-deductible, leading to an increase in the value of the firm.
What are bankruptcy costs, and how do they impact capital structure?
Bankruptcy costs include both direct costs (e.g., legal fees) and indirect costs (e.g., lost sales, managerial distraction). As debt increases, the risk of bankruptcy rises, which can offset the tax shield advantage of debt.
What role do agency costs play in the Modigliani-Miller theory?
Agency costs arise from conflicts of interest between stakeholders (e.g., stockholders vs. bondholders, managers vs. shareholders), and they influence the firm’s capital structure decisions. For example, more debt can align interests, but it can also exacerbate conflicts.
How does Modigliani and Miller’s theory explain the choice between debt and equity in capital structure?
According to their theory, in a perfect market, there is no advantage to using debt or equity; the firm’s value is determined by its assets and investment decisions, not by how it finances those assets.
What does the trade-off theory of capital structure suggest as an improvement to Modigliani-Miller’s theory?
The trade-off theory suggests that firms balance the tax shield benefits of debt against the costs of bankruptcy and agency problems to determine an optimal capital structure.
What is the “pecking order theory” in relation to capital structure?
The pecking order theory suggests that firms prefer to finance new investments first with internal funds, then with debt, and finally with equity, due to the costs of asymmetric information.
Why do the assumptions of the Modigliani-Miller theory not fully reflect reality?
These assumptions, such as no taxes, no bankruptcy costs, and no transaction costs, are unrealistic in real-world markets. In reality, taxes exist, bankruptcy costs are significant, information asymmetry exists, and firms face transaction costs. These factors make capital structure decisions more complex and relevant.
What does Modigliani & Miller Proposition II state in a world without taxes?
As a firm increases its debt, the cost of equity increases linearly to compensate for the higher financial risk, keeping the firm’s overall cost of capital (WACC) constant.
Why does the cost of equity rise as a firm increases its debt in MM Proposition II?
Because equity holders bear more financial risk as debt increases, so they require a higher return to compensate.
What is the formula for cost of equity in MM Proposition II (no taxes)?
rE=rU+(ED)(rU−rD )
Where:
rE : Cost of equity
rU: Cost of capital for an unlevered firm
rD: Cost of debt
D/E: Debt-to-equity ratio
Q4: In our example with 30% debt
Why is the WACC constant in MM Proposition II without taxes?
Because the increase in cost of equity exactly offsets the benefit of cheaper debt, making capital structure irrelevant to firm value.
What is the economic intuition behind MM Proposition II?
Investors can replicate leverage themselves (homemade leverage), so the market doesn’t reward or penalize a firm based on its capital structure in a perfect market.
Why doesn’t capital structure affect firm value in this theory?
Because there are no taxes, bankruptcy costs, agency problems, or information asymmetries to create preferences between debt and equity.
What happens if we increase the firm’s debt further?
The cost of equity increases even more, but the WACC remains unchanged, keeping the firm’s value constant.
