MM Proposition 1 (no taxes): The capital structure irrelevance proposition
In 1958, under a very restrictive set of assumptions, MM proved that the value of a firm is unaffected by its capital structure. To summarize, MM's results suggest that in a perfect world, it does not matter how a firm finances its operations, so the value of the company is determined by the discounted present value of its operating earnings. Thus, capital structure is irrelevant. MM's study is based on the following simplifying assumptions:
1. Capital markets are perfectly competitive: there are no transaction costs, taxes, or bankruptcy costs.
2. Investors have homogeneous expectations: they have the same expectations with respect to cash flows generated by the firm.
3. Riskless borrowing and lending: investors can borrow/lend at the risk-free rate.
4. No agency costs: no conflict of interest between managers and shareholders.
5. Investment decisions are unaffected by financing decisions: operating income is independent of how assets are financed.
Under the assumption of capital markets, the sum of the firm's debt and equity should equal the value of the all equity company so the value of the company is unchanged. Another way of stating this is that the value of the company with the leverage is equal to the value of the company without leverage. V(L) = V(U)
Given our assumptions, an investor can have homemade leverage. He can substitute his on leverage (in addition to owning stock) for company's leverage. As this process is assumed to be costless, a company's capital structure is irrelevant in the presence of perfect capital markets.
MMProposition II (no taxes): Cost of Equity and Leverage Proposition
MM's second proposition with no taxes states that the cost of equity increases linearly as a company increases its proportion of debt financing. Again, MM assume a perfect market where there are no taxes, no cost of bankruptcy, and homogeneous expectations. According to their proposition, debtholders have a priority claim on assets and income, which makes the cost of debt lower than the cost of equity. However, as companies increase their use of debt, the risk to equityholders increases, which in turn increases the cost of equity. Therefore, the benefits of using a larger proportion of debt as a cheaper source of financing are offset by the rise in the cost of equity, resulting in no change in the firm's WACC. Because the benefits of lower cost debt are offset by the increased cost of equity, the relative amount of debt versus equity in the firm's capital structure does not affect the overall value of the firm.
MM Proposition I (with taxes): Value is Maximized at 100% Debt
Tax shield provided by debt. Removing MMs assumption that there are no taxes changes the result of their proposition regarding capital structure irrelevance. The differential tax treatment within different countries encourages firms to use debt financing because that provides a tax shield that adds to the value of the company. The tax shield is equal to the marginal tax rate multiplied by the amount of debt in the capital structure. In other words, the value of a levered firm is equal to the value of an unlevered firm plus the tax shield. If we maintain MM's other assumptions (i.e. no cost of bankruptcy), the value of the company increases with increasing levels of debt, and the optimal capital structure is 100% debt.
MM Proposition II (with taxes): WACC is minimized at 100% debt
The value of the firm is maximized at the point where the WACC is minimized, which is 100% debt.
Costs and Their Potential Effect on the Capital Structure
> Costs of financial distress are the increased costs a company faces when earnings decline and the firm has trouble paying its fixed financing costs. Higher expected costs of financial distress tend to discourage companies from using large amounts of debt in their capital structure, all else equal.
> Agency costs of equity refer to the cost associated with the conflicts of interest between managers and owners. Managers who do not have a stake in the company do not bear the costs associated with excessive compensation or taking on too much (or too little) risk. Because shareholders are aware of this conflict, they will take steps to minimize these costs, and the net result is called the net agency cost of equity. The agency cost of equity has three components: (1) monitoring costs are the costs associated with supervising management and include the expenses associated with making the reports to shareholders and paying the Board of Directors. (2) bonding costs are assumed by management to assure shareholders that the managers are working in the shareholders' best interest. (3) residual losses may occur even with adequate monitoring and bonding provisions because such provisions do not provide a perfect guarantee.
> Costs of asymmetric information refer to costs resulting from the fact that managers typically have more information about a company's prospects and future performance than owners and creditors. The cause of asymmetric information increases as the proportion of equity in the capital structure increases.
Pecking order theory, based on asymmetric information, is related to the signals management sends to investors through its financing choices. According to pecking order theory, managers prefer to make financing choices that are least likely to send signals to investors. In other words the pecking order (from most favored to least favored) is:
1. internally generated equity (i.e. retained earnings).
3. External equity (i.e. newly issued shares).
Therefore, the pecking order theory predicts that the capital structure is a byproduct of the individual financing decisions.
Static Trade-Off Theory
The static trade off seeks to balance the cost of financial distress with the tax shield benefits from using debt. Under the static trade off theory, there is an optimal capital structure that has an optimal proportion of debt.
If we remove the assumption that there are no costs of financial distress, there comes a point where the additional value added from the debt tax shield is exceeded by the value reducing costs of financial distress from the additional borrowing. This point represents the optimal capital structure for a firm where the WACC is minimized and the value the firm is maximized. Accounting for the costs of financial distress, the expression for the value of a levered firm becomes: V(L) = V(U)+(t x d)-PV(costs of financial distress)
The optimal proportion of debt is reached at the point where the marginal benefit provided by the tax shield of taking on additional debt is equal to the marginal costs of financial distress incurred from the additional debt.