Question

Rachel’s Crab Heaven (RCH) supplies crabs, fish, and clams to restaurants along the east coast. Rachel is sole owner and chief executive. She currently has one fishing vessel but is considering investing in one that would increase her daily harvest two to three fold. Rachel estimates the new vessel would generate an operating cash flow of $207,000 per year for eight years. The vessel has an initial investment of $1,250,000. Rachel will borrow the entire amount from First Bank at 6.2%.

Suppose instead of a bank loan, Rachel decided to finance the purchase with both a bank loan and an equity issue. Describe the differences between the two sources of capital and the implications for capital structure as described by MM and the optimal level of debt.

Answer 1

The Capital Structure of a firm constitutes mainly the owners funds and the borrowed capital. The owners funds come in the shape of their contributions made voluntarily known as shares which are of two types viz., the equity shares and preference shares. Borrowed capital is in the form of Loans, deposits and debentures etc.,

Equity shares, commonly referred to as ordinary shares also represents the form of fractional ownership in which a shareholder, as a fractional owner, undertakes the maximum entrepreneurial risk associated with a business venture. The holder of such shares are member of the company and have voting rights

All the capital requirements cannot be fulfilled by the promoters or equity share issues and that is where the term loans come into picture. Term loan or project finance is a long term source of finance for a company normally extended by financial institutions or banks for a period of more than 5 years to a maximum of around 10 years. One common feature which helps management in relatively substituting equity by term loans is the longer term of the loan.

In 1958, Franco Modigliani Miller (MM) published a theory of modern financial management – they concluded that the value of a firm depends solely on its future earnings stream, and hence its value is unaffected by its debt/equity mix. In short, they concluded that a firm’s value stems from its assets, regardless of how those assets are financed.

In their paper, MM began with a very restrictive set of assumptions, including perfect capital markets (which implies zero taxes). And then they used an arbitrage proof to demonstrate that capital structure is irrelevant. Under their assumptions, if debt financing resulted in a higher value for the firm than equity financing, then investors who owned shares in a leveraged (debt-financed) firm could increase their income by selling those shares and using the proceeds, plus borrowed funds, to buy shares in an unleveraged (all equity financed) firm.The simultaneous selling of shares in the leveraged firm and buying of shares in the unleveraged firm would drive the prices of the stocks to the point where the values of the two firms would be identical. Thus, according to MM Hypothesis, a firm’s stock price is not related to its mix of debt and equity financing.
Modigliani and Miller have restated and amplified the net operating income position in terms of three basic propositions. These are as follows:
Proposition – I
The total value of a firm is equal to its expected operating income (PBIT when tax = 0) divided by the discount rate appropriate to its risk class. It is independent of the degree of leverage.
V_I=V_u= EBIT/K_oI = EBIT/K_ou
Here the subscript l is used to denote leveraged firm and subscript u is used to denote unleveraged firm. Since the V (Value of the firm) as established by the above equation is a constant, then under the MM model, when there are no taxes, the value of the firm is independent of its leverage. This implies that the weighted average cost of capital to any firm is completely independent of its capital structure and the WACC for any firm, regardless of the amount of debt it uses, is equal to the cost of equity of unleveraged firm employing no debt.
Proposition – II
The expected yield on equity, Ke is equal to Ko plus a premium. This premium is equal to the debt – equity ratio times the difference between Ko and the yield on debt, Kd. This means that as the firm’s use of debt increases its cost of equity also rises, and in a mathematically precise manner.
Proposition – III
The cut-off rate for investment decision making for a firm in a given risk class is not affected by the manner in which the investment is financed. It emphasizes the point that investment and financing decisions are independent because the average cost of capital is not affected by the financing decision.

To sum up: Simply stated, the Modigliani Miller approach is based on the thought that no matter how the capital structure of a firm is divided among debt, equity and other claims, there is a conservation of investment value. Since the total investment value of a corporation depends upon its underlying profitability and risk, it is invariant with respect to relative changes in the firms financial capitalization. The approach considers capital structure of a firm as a whole pie divided into equity, debt and other securities. According to MM, since the sum of the parts must equal the whole, therefore, regardless of the financing mix, the total value of the firm stays the same.