AC6101

Capital Structure
Modigliani and Millar
 The “cheaper debt” fallacy
• For a given firm, the cost of debt will always be
lower than the cost of equity, since debt is less
risky for investors.
• Therefore – firms can reduce their cost of capital
(and increase their value) by using more debt and
less equity to finance their assets, right? Wrong
• As firms use more (cheap) debt, their remaining
equity becomes more risky and therefore more
expensive, exactly off-setting the effect of debt.
 Modigliani & Millar (1): Capital Structure
is Irrelevant to Firm Value
The key assumptions:
• There is no taxation: personal or corporate
• There are perfect capital markets, with perfect information available to all economic
agents and no transaction costs
• There are no costs of financial distress and liquidation
• Firms can be classified into distinct risk classes
• Individuals can borrow at the same rate as corporations
 Modigliani and Miller’s argument
in a world with no taxes
•MM proposed that the financing mix of a firm could not alter it’s value
Proposition 1
“The value of a levered firm is equal to the value of an unlevered firm with
identical expected cash-flows and
The cost of capital to any firm is independent of its capital structure and is equal
to the capitalisation rate of a pure equity stream of its risk class.”

The WACC is constant because the cost of equity capital rises to exactly offset
the effect of cheaper debt (see Prop II)

•The total market value of the firm is the net present value of the income stream.
For a firm with a constant perpetual income stream:

C1
V = –––––––
WACC
 Proposition II
The expected rate of return on equity increases proportionately with the
gearing ratio
- As gearing increases financial risk increases, shareholders demand
premium to compensate i.e. discount rate applied to equity increases to off-set
increased expected return.
WACC = (E/V) x Ke + (D/V) x Kd
Ke = WACC + (WACC - Rd) x (D/E)
Where:
Ra = Required rate of return on the firm's assets (Weighted Average Cost of Capital)
Re = Cost of Equity Capital (aka - Ke)
Rd = Cost of debt of the firm (assumed to be the risk free rate)
D/E = Debt/Equity ratio of the firm
E/V = Equity/Value ratio of the firm

Propositions I and III follow from Proposition II

 Proposition III
– The cut-off rate of return for new projects is equal to the weighted
average cost of capital – which is constant regardless of gearing
 Arbitrage Proof of M&M
Example - Macbeth Spot Removers - All Equity Financed
Data
Number of shares 1,000
Price per share €10
Market Value of Shares € 10,000

Outcomes
A B C D
Operating Income €500 1,000 1,500 2,000
Earnings per share €.50 1.00 1.50 2.00
Return on equity (%) 5% 10 15 20
 Arbitrage Proof of M&M
Data
Example
Number of shares 500
cont. Price per share €10
50% debt Market Value of Shares € 5,000
Market value of debt € 5,000

Outcomes
A B C D
Operating Income €500 1,000 1,500 2,000
Interest €500 500 500 500
Equity earnings €0 500 1,000 1,500
Earnings per share €0 1 2 3
Return on equity (%) 0% 10 20 30
 Arbitrage Proof of M&M
Macbeth - Firm is All Equity Financed
but now Debt replicated by investors
Investor invests €10 and borrows another €10 to
purchase 1 additional share.

Outcomes
A B C D
Earnings on two shares €1.00 2.00 3.00 4.00
LESS : Interest @ 10% €1.00 1.00 1.00 1.00
Net earnings on investment €0 1.00 2.00 3.00
Return on €10 investment (%) 0% 10 20 30
 Arbitrage
• Two securities with identical E(r) & risk will
trade at the same price.
• In the Macbeth example investors can create
exactly the same security as a share in the
levered company by borrowing themselves
• They will not pay a premium for a levered
company.
 Example: Pivot plc
•It needs £1m capital to buy machines, plant and buildings
•Equity required return is 15 per cent
•All earnings paid out to shareholders as dividends at each year end
•Expected annual cash flow is a constant £150,000 in perpetuity
•Structure 1: All-equity (1,000,000 shares selling at £1 each)
•Structure 2: £500,000 of debt capital with an interest rate of 10 per cent per
annum. Plus £500,000 of equity capital (500,000 shares at £1 each)
•Structure 3: £700,000 of debt capital with an interest rate of 10 per cent per
annum. Plus £300,000 of equity capital (300,000 shares at £1 each)

•Calculate Re for each of the possible capital structures

•Calculate Ra for each of the possible capital structures
 Pivot plc.
Cost of Equity (Re) in each Capital Structure
Capital Structure Calculation Re
Re = Ra + (Ra - Rd) x (D/E)

All Equity .15 + (.15 - .10) * 0 15%

50% Debt .15 + (.15 - .10) * 1 20%

70% Debt .15 + (.15 - .10) * (7/3) 26.67%

 Pivot plc.
Cost of Capital (Ra) in each Capital Structure
Capital Structure Calculation Ra
Ra = (E/V) x Re + (D/V) x Rd

All Equity (1) * .15 + (0) * .1 15%

50% Debt (0.5) * .20 + (0.5) * .1 15%

70% Debt (0.3) * .267 + (0.7) * .1 15%

Pivot plc: capital structure and returns to
shareholders
Pivot plc: capital structure and value of the firm
The cost of debt, equity and the WACC under
the MM no-tax model
If WACC is constant and cash flows do not change,
then the total value of the firm is constant

V = VE + VD = £1m
C1 £150,000
V = –––––––– = –––––––––– = £1m
WACC 0.15
 Leverage is Irrelevant

MM'S PROPOSITION I (No Taxes)

• If capital markets are doing their job, firms
cannot increase value by tinkering with
capital structure.
• Investors can replicate the effect of debt on returns
themselves so will not pay a premium for a firm to do so.
• V is independent of the debt ratio under these assumptions.
 Introducing Taxes
• Key assumption of M&M propositions is that firms are not subject to
corporation tax.
• This ignores the tax benefit we examined earlier, which reduces cost of
debt.
• Once tax is introduced a different result emerges.
 M&M & Corporate Taxes
The tax deductibility of interest increases the aggregate
distributed income to bondholders and shareholders.

Income Income
Statement of Statement of
Firm U Firm L
Earnings before interest and taxes $1,000 $1,000
Interest paid to bondholders - 80
Pretax income 1,000 920
Tax at 35% 350 322
Net income to stockholders 650 598

Total income to both bondholders and

stockholders $0+650=$650 $80+598=$678

Interest tax shield (.35 x interest) $0 $28

 M&M & Corporate Taxes
Example - You own all the equity of Space Babies Diaper Co.
The company has no debt. The company’s annual cash
flow is $900,000 before interest and taxes. The corporate
tax rate is 35% You have the option to exchange 1/2 of
your equity position for 5% bonds with a face value of
$2,000,000. The companies current cost of capital is 5%

Should you do this and why?

 M&M & Corporate Taxes
Example - You own all the equity of Space Babies Diaper Co. The company
has no debt. The company’s annual cash flow is $900,000 before interest
and taxes. The corporate tax rate is 35% You have the option to
exchange 1/2 of your equity position for 5% perpetuity bonds with a face
value of $2,000,000.
Should you do this and why?

($ 1,000 s) All Equity 1/2 Debt

Total Cash Flow
EBIT 900 900
All Equity = 585
Interest Pmt 0 100
Pretax Income 900 800
Taxes @ 35% 315 280 *1/2 Debt = 620
Net Cash Flow 585 520 (520 + 100)
 M&M & Corporate Taxes
PV of Tax Shield = D x rD x Tc
(assume perpetuity) = D x Tc
rD

Example:
Tax benefit = 2,000,000 x (.05) x (.35) = $35,000
PV of $35,000 in perpetuity = 35,000 / .05 = $700,000

Shortcut PV Tax Shield (perpetual debt only)

= $2,000,000 x .35 = $700,000
 M&M & Corporate Taxes
Firm Value =
Value of All Equity Firm + PV Tax Shield

Space Babies Diaper Co:

All Equity Value = 585 / .05 = 11,700,000

PV Tax Shield = 700,000

Firm Value with 1/2 Debt = $12,400,000

 M&M
Propositions I & III with Corporate Taxes
• One of the assumptions in original MM is no
corporate taxes
• Introduction of taxes significantly alters models
conclusions.

“The value of a levered firm is greater than the value of an otherwise

identical unlevered firm by the amount of debt multiplied by the tax
rate”
or
“The weighted average cost of capital declines as the ratio of debt to equity
increases, although the cost of equity increases linearly in proportion to
the relationship between the cost of capital of an unlevered firm and the
after tax cost of debt.”
 The capital structure decision in a
world with tax
•The introduction of taxation brings an additional advantage to using debt
capital: it reduces the tax bill and therefore increases after tax cash-flows
•In a 30 per cent corporate tax environment a profitable firm’s cost of debt
falls from a pre-tax 10 per cent to only 7 per cent after the tax benefit:
•10% (1 – T) = 10% (1 – 0.30) = 7%
 Key messages of M&M
• Absent taxes:
– WACC and value are not related to capital
structure.
– WACC is constant and is equal to the unlevered
cost of equity.
• With corporate taxes
– WACC declines as debt is added due to the tax
benefit of debt
 Criticisms of MM & Miller Models
• Main objections
– Assumptions not realistic
– Ignores costs of financial distress and agency costs
• Note though that firms did increase their use of debt
after MM’s findings were published
• Note that M&M’s propositions are theorems – they
are demonstrably true under their assumptions.