Question

A firm’s capital structure is the particular distribution of debt and equity that makes up the finances of a company.

a) What does Modigliani-Miller Proposition I (MM I) suggest regarding the choice between debt and equity?

b) Modigliani-Miller Proposition II (MM II), proposes that the cost of equity increases dramatically with high levels of debt. Explain why this occurs.

Answer 1

a). MM I tends to operate on the assumption of perfectly efficient markets.

Perfectly efficient markets imply that:

• Companies do not have to pay any taxes
• There are no transaction costs related to the trading of securities
• No bankruptcy costs
• There is no information asymmetry

Now, MM I states that the Value of the unlevered firm (financing only through equity) is same as the value of the levered firm (financing through a mix of debt and equity).

In other words, the firm's capital structure does not impact the firm's value.

This can easily be understood as since there are no taxes (remember our assumption of perfectly efficient markets above), the company with a 100% leveraged capital structure has no any benefits from tax-deductible interest payments.

Similarly, in terms of equity, there's no information asymmetry and no transaction charges. Thus the market always reflects the correct price!

Hence, MM I is indifferent between debt and equity when it comes to choosing one.

b). M&M II states that the firm's cost of equity is in direct proportion to the company’s level of debt.

By plain logic, the increase in leverage level induces higher default probability to a company. That is, the higher debt the company has, the riskier it becomes as an investment opportunity. Therefore, the equity investors tend to demand a higher return, i.e., a higher cost of equity (return) to be compensated for additional risk.

This can also be represented methamatically as:

R(e) = R(a) + (D/E) * (R(a) - R(d))

Where, R(e) is cost of equity, R(a) is cost of unlevered equity, R(d) is cost of debt and D/E is debt to equity ratio.

As can also be seen from the formula, as R(d) increases, R(e) increases.