Assumptions Behind the MM Propositions
No taxes and financial distress costs, no asymmetric information, no transaction costs, managers
and employees always work to maximize the value of the firm, individuals and firms can borrow and
lend at the same rates
MM Proposition 1:
In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure.
Modigliani-Miller (MM) Proposition 2
Let 𝐸 = market value of equity, 𝐷 = market value of debt, 𝑈 = market value of unlevered equity, and 𝐴 =market value
of the firm’s assets
MM Proposition 2: The cost of capital of levered equity increases with the firm’s market value debt-equity ratio
Consider a polluting firm that risks being subject to a high carbon tax in the future
Given the simplified assumptions in MM, would this be reflected in firm valuation and cost of capital in the MM model?
The cost of financially material E and S externalities on financial capital structure is already captured in
the basic MM model
What are 5 fallacies related to capital structure that Modigliani-Miller helps to address
- Debt is Cheap Fallacy
- EPS Fallacy
- Equity Issue Dilution Fallacy
- Repurchases vs Dividends
- Cash Hoarding
(1) Fallacy: ”Debt is cheaper than equity because it has a low interest rate”
What is wrong with this argument?
WACC will stay the same
* increasing leverage comes at the cost of increasing the cost of equity capital
* Increasing leverage to a point where debt is risky, the required return on debt also increases
(2) Fallacy: “Debt is desirable when it increases earnings per share (EPS)”
This fallacy implies that leveraging through debt always increases earnings per share (EPS). However, it ignores the financial risks and costs of debt, which might not necessarily result in increased EPS. While EPS in example has indeed gone up, so has the risk and therefore required return on equity. Moreover, while EPS might increase, the share price might not increase.
- EPS can go up (or down) when a company increases its leverage ⇒ true
- Companies should choose their financial policy to maximize their EPS ⇒ false
(3) Fallacy: ”Equity is more expensive than debt because equity issues dilute the earnings per share and drive down the stock price”
- Equity issuance = flipside of repurchase → reduction in leverage
We have seen that earnings per share are indeed lower when leverage is lower - But the value of the shares is the same; extra EPS in levered firm is compensation for risk
- Original shareholders are not worse off when issuing shares
(4) Fallacy: ”Paying out cash through share repurchases is better than dividends because repurchases support the share price.”
There is no “Mechanical effect” that shows why is better than the other.
(5) Fallacy: “The company should pay out its cash rather than just invest in government bonds at a low interest rate. This would increase investor returns.”
- Overall, payout policy does not matter under MM if retained cash flow earns a fair market return
The payout policy argument is the same as the debt irrelevance argument - Important principle: deciding how much debt to take on and deciding how much cash to pay out is
essentially the same decision - Cash = Negative Debt!
- This is why we should consider Net Debt = Debt – Excess Cash when we evaluate capital structure
(see your valuation course).
What is the tradeoff theory?
MM debunks the “debt is cheap” and many other fallacies
* The picture changes once we introduce taxes and bankruptcy cost
* Now the government wants its slice as well
* If taxes are paid on earnings after interest payments, debt is cheaper than equity financing
* But high leverage increases bankruptcy cost → trade-off theory
* Tradeoff Theory: the firm picks its capital structure by trading off the benefits of the tax shield from debt against the costs of financial distress
How do you calculate the tax schield
Interest tax shield = (corporate tax rate) × (interest payments)
What is the updated MM Proposition 1 (with taxes)
the total value of the levered firm exceeds the value of the firm without
leverage due to the present value of the tax savings from debt:
What is the MM Proposition 2 with taxes
With tax-deductible interest, the effective after-tax borrowing rate is
𝑟(1 − 𝜏c) and the weighted average cost of capital becomes:
What is the The low Leverage Puzzle
If capital structure was only about taxes, firms should have relatively
high leverage
* This is not the case: it would appear that firms, on average, are underleveraged.
* There seems to be more to the story:
* Bankruptcy costs
* Agency costs
* Asymmetric information costs
MM does account for financial distress & bankruptcy. However, there is an important assumption they make
MM assumption: when the value of equity falls to zero (limited liability), debt holders take over the firm at no cost
When a firm fails to make a required payment to debt holder this is called default. what are the two bankruptcy proceedings?
Bankruptcy proceedings
* Liquidation: sell all assets of the firm and use the proceeds to pay debt holders
– For large firms, this is very costly and takes a long time
* Reorganization: management proposes reorganization plan and continues to operate the business
– Goal is to continue operating the firm rather than liquidating all assets
– Creditors receive cash payments and new securities in firm and can vote to accept/reject the plan
Financial vs Economic Distress
Difference
A firm that makes significant losses is in economic distress
* Whether economic distress results in financial distress depends on the firm’s leverage
* An all-equity (unlevered) firm can be in economic distress, but it will never face bankruptcy
What are the three key factors determine the present value of financial distress costs
- The probability of financial distress
* Increases in leverage, cash flow volatility and asset volatility - The magnitude of the costs after a firm is in distress
* Direct + indirect costs
* Higher for firms with more intangible assets and important employee and customer relationships (e.g. technology firms) - The appropriate discount rate for the distress costs
* Depends on the firm’s market risk
What are some examples of indirect costs bankruptcy
- Missed investment opportunities
- Ability to compete in product markets
- Loss of customers, employees and suppliers
- Fire sale of assets
- Delayed liquidation
- Loss of receivables
- Costs to creditors
Net benefit of debt formula
Optimal level of debt
(PV tax shield - PV cost of distress)
