Capital Structure Theory

This theory recognizes the tax benefits accrued by interest payments. In other words, the actual cost of debt is less than the nominal cost of debt due to tax benefits. The trade-off theory advocates that a company can capitalize its requirements with debts as long as the cost of distress, i.e., the cost of bankruptcy, exceeds the value of the tax benefits. Thus, the increased debts, until a given threshold value, will add value to a company. The Modigliani and Miller Approach further state that the operating income affects the market value of the firm, apart from the risk involved in the investment. The theory stated that the value of the firm is not dependent on the choice of capital structure or financing decisions of the firm.

modigliani and miller

This is not to be confused with the value of the equity of the firm. Since the value of the firm depends neither on its dividend policy nor its decision to raise capital by issuing stock or selling debt, the Modigliani–Miller theorem is often called the capital structure irrelevance principle. According to MM, the above is an exhaustive list of how capital structure decisions can affect firm value. The capital structure of a company is the way a company finances its assets. A company can finance its operations by either equity or different combinations of debt and equity. The capital structure of a company can have a majority of the debt component.

Journal Of Economic Theory

MMIII holds that the weighted average cost of capital to the firm is independent of capital structure. It says that financial leverage is in direct proportion to the cost of equity. With an increase in the debt component, the equity shareholders perceive a higher risk to the company. Hence, in return, the shareholders expect a higher return, thereby increasing the cost of equity. A key distinction here is that Proposition 2 assumes that debt shareholders have the upper hand as far as the claim on earnings is concerned. The irrelevance proposition theorem is a corporate capital structure theory that posits that financial leverage has no effect on the value of a company. Lawyers who have taken a class in corporate finance would have seen the MM theorem, and if they remember it, they probably consider it irrelevant to their work.

modigliani and miller

Thus, the commitment view is an example of a violation of the first MM assumption of informationally perfect markets. The debate usually takes the form of which approach is better—favoring managers or shareholders—which is to say whether the agency costs from manager control are greater than the costs resulting from imperfect information with shareholder control. The same relationship as earlier described stating that the cost of equity rises with leverage, because the risk to equity rises, still holds. The formula, however, has implications for the difference with the WACC. Thus, as applied to the reverse MM theorem, Fennell and McAdams’ analysis suggests several reasons why the reverse MM theorem might not have caught on.

Modigliani And Miller Mm

Whether a firm is high on leverage or has a lower debt component in the financing mix has no bearing on the value of a firm. The Modigliani and Miller approach to capital theory, devised in the 1950s, advocates the capital structure irrelevancy theory. This suggests that the valuation of a firm is irrelevant to the capital structure of a company.

Without taxes the firm does not benefit from financing with debt. So in effect, you cannot lower your cost of capital by exchanging debt for equity. `D` and `E` are the market values of the firm’s debt and equity respectively. By doing so investors create leveraged firms, which increases the values of these firms, earning the investors profits. If they do, and leveraged firms are priced higher than unleveraged firms, then investors can buy the unleveraged firms on margin. Whether such an capital structure exists, and the method of finding it, has long been of interest in finance.

The no-arbitrage proof has also become part of financial economists’ standard toolkit and was applied in many prominent works, such as the development of the put-call parity in option pricing theory. The first view, the shareholder primacy position, is often described as the agency model, and it emphasizes the agency costs from having managers make decisions on behalf of shareholders. As such, the agency model is a straightforward example of a violation of the second MM assumption of frictionless markets.

What Is The Modigliani

In addition, a more thorough analysis would describe how directors should be compensated and how much effort they should apply to each firm. The airline industry is capital-intensive , volatile, and low-profit. Accordingly, if the airlines took all of the depreciation deductions from the aircraft they operated, they would frequently realize little or no value from doing so.

  • Homemade dividends are a form of investment income that comes from the sale of a portion of one’s portfolio.
  • In an aircraft lease, a third party takes title and leases the aircraft to the airline.
  • Is possible but there are no bankruptcy costs, and information is perfectly symmetrical.
  • In addition, a more thorough analysis would describe how directors should be compensated and how much effort they should apply to each firm.

That is if a firm pays a 5% yield on its debt, it will have to earn, say, 9% on its equity. So people often assume firms should borrow to take advantage of the cheaper rate.

Proposition I

Since the value of a company is calculated as the present value of future cash flows, the capital structure cannot affect it. Also, in perfectly efficient markets, companies do not pay any taxes. Therefore, the company with a 100% leveraged capital structure does not obtain any benefits from tax-deductible interest payments. The M&M framework and methodology had a major impact in shaping future research. In the decades that followed, the corporate finance literature was significantly enriched by attempts to relax various original M&M assumptions, such as no taxation and no bankruptcy costs.

For most practicing transactional lawyers, the suggestion that much of their work is an application of the reverse MM theorem is likely to be met with either a shrug or resistance. Immersed in the details of a transaction while focused on the competitive aspects of the negotiations, it is easy to lose sight of the big picture and the scaffolding on which it stands. The reverse MM theorem is that scaffolding, and the lawyer who has internalized that theorem has a powerful framework that can be used to help to identify problems and tailor solutions for her client even in complex and novel situations.

Capital Structure Theory

Although aircraft leasing can be understood without reference to the reverse MM theorem, the theorem focuses on the relevant issues—taxes and incentives—the optimal balance among which changed as the legal regime changed. Used in this way, the reverse MM theorem operates as a template to understand alternative transactional structures and their development over time.

In effect, the airline transfers the depreciation tax benefits to the lessor in exchange for a lower lease rate. In a simple lease, the lessor would purchase the aircraft for cash, tying up capital. Because it is the lessor’s tax attributes—and only those tax attributes—that make it the preferred owner, most aircraft leases are leveraged leases.

What Is The M&m Theorem?

Implicit in the exercise is the assumption that the observed structure is the structure that maximizes value. The theorem is then being used to explain why the observed practice is optimal. Scholars can also use the reverse MM theorem prescriptively to criticize existing structures and to develop recommendations for improved structures. The most well-known of Miller’s solo work on taxation and capital structures is Miller’s presidential address to the American Finance Association, which was published as Merton H. Miller, Debt and Taxes, 32 J. Thus, Jensen and Meckling developed a theory of capital structure that exploits the notion that the second MM assumption, frictionless markets, is false. The contrapositive of a theorem “if A, then B,” is “if not B, then not A.” If a theorem is true, its contrapositive must be true. The reverse MM theorem adds economic content because capital structure must affect value through the MM assumptions .

modigliani and miller

Miller and Modigliani published a number of follow-up papers discussing some of these issues. The Modigliani-Miller theorem argues that the option or combination of options that a company chooses has no effect on its real market value. Companies have only three ways to raise money to finance their operations and fuel their growth and expansion. They can borrow money by issuing bonds or obtaining loans; they can re-invest their profits in their operations, or they can issue new stock shares to investors.

Accordingly, because it is easier to delay litigation than to accelerate it, and because a non-market interest rate gives one party an incentive to delay , a fixed rate obligation is likely to lead to delay . If interest rates have gone up , the defendant will have incentive to delay; alternatively, if interest rates have gone down , the plaintiff will have incentive to delay. In contrast, with a floating market interest rate, because the plaintiff is not receiving an above-market interest rate and the defendant is not paying a below-market rate neither party has an incentive to delay. The Modigliani and Miller Approach assumes that there are no taxes, but in the real world, this is far from the truth.

The implied return on equity is the inverse of the price-earnings ratio or the earnings-price ratio. According to Miller, at the time they were working on their first article, interest rates on corporate debt were around three to five percent, whereas the cost of equity capital ran from fifteen to twenty percent. Merton H. Miller, The Modigliani-Miller Propositions After Thirty Years, 2 J. Nonetheless, the presence of tax shields affects the relationship by making the cost of equity less sensitive to the leverage level. Although the extra debt still increases the chance of a company’s default, investors are less prone to negatively reacting to the company taking additional leverage, as it creates the tax shields that boost its value. A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt.

A young lawyer who has internalized the reverse MM theorem should find it easier to acquire, store, retrieve and apply the relevant skills and knowledge required to progress. For examples in the legal literature where the reverse MM theorem is explicitly drawn upon, see sources cited in supra note 4. The Modigliani and Miller Approach indicates that the value of a leveraged firm is the same as the value of an unleveraged firm . That is, if an investor purchases shares of a leveraged firm, it would cost him the same as buying the shares of an unleveraged firm.

Proposition 2

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