What are views of Modigliane and Miller on the capital structure?

Answer 1

Franco Modigliani and Merton Miller (MM) produced the Modigliani-Miller Theorem, also referred to as the Capital Structure Irrelavence Theorem, that forms the basis of modern capital structure thinking. The basic theorem states that, under the random walk, in the absence of taxation, bankruptcy costs and in an efficient market, the value of a firm is unaffected by how it is financed (BPP, 2006).

Modigliani-Miller Theorem with no taxes

Initially the theory was proven in a situation with no taxes. Take for example two companies that are exactly the same in all respects other than the fact that Company A is unlevered and Company B is levered. The financial results for the two firms are as follows.

Company A Company B

£ £

Earnings 1,000 1,000

Interest - (400)

Dividends 1,000 600 .

Both firms pay out all earnings each year, either as dividends to equity investors, interest to debt investors, or a combination of the two. MM pointed out that both Company A & B paid out all their earnings to investors, whether this was paid as dividend or interest is irrelevant, and as cash flows are the same in the hands of their investors they must have the same total market value. The theory predicts two main points.

Proposition 1:

VU =VL where VU is the value of an unlevered company and VL is the value of a levered form.

Proposition 2:

· ke = required rate of return on equity, or cost of equity.

· ko = cost of capital for an all equity firm.

· Kd = required rate of return on borrowings, or cost of debt.

· D / E = the debt-to-equity ratio.

This formula is derived from the theory of WACC, a higher D/E leads to higher required return on equity due to increased risk involved for equity holders.

Modigliani-Miller Theorem with taxes

MMs initial theory was later developed to include taxation.

Proposition 1; VL = VU + TcD

· TcD is the tax rate x the value of debt.

· VL = the value of a levered firm

· Vu = the value of an unlevered firm.

The assumption is made that debt is perpetual. This equations suggests the advantage of leveraging because firms will reduce tax bills by deducting interest payments, where dividends are non-deductable.

Proposition 2:

· rE = required rate of return for equity, or cost of equity.

· RO = the cost of capital for an all equity firm.

· rD = required rate of return on borrowings, or cost of debt.

· D/E = debt-to-equity ratio.

· Tc = tax rate.

MMs revised theory of capital structure with the inclusion of taxation identified that as a level of gearing increases, equity can is replaced with cheap debt and WACC is reduced. Therefore an optimal capital structure exists at a point of 100% debt.

Assumptions are still present in the updated model; corporations are taxed at the Tc rate on earnings after interest, no transaction costs exist and individuals and corporations borrow at the same rate.