Financial Leverage And Capital Structure Policy -

Modigliani And Miller's Capital Structure Theories

Modigliani and Miller, two professors in the 1950s, studied capital-structure theory

intensely. From their analysis, they developed the capital-structure irrelevance

proposition. Essentially, they hypothesized that in perfect markets, it does not matter

what capital structure a company uses to finance its operations. They theorized that

the market value of a firm is determined by its earning power and by the risk of its

underlying assets, and that its value is independent of the way it chooses to finance its

investments or distribute dividends.

The basic M&M proposition is based on the following key assumptions:

No taxes

No transaction costs

No bankruptcy costs

Equivalence in borrowing costs for both companies and investors

Symmetry of market information, meaning companies and investors have the

same information

No effect of debt on a company's earnings before interest and taxes

Of course, in the real world, there are taxes, transaction costs, bankruptcy costs,

differences in borrowing costs, information asymmetries and effects of debt on

earnings. To understand how the M&M proposition works after factoring in corporate

taxes, however, we must first understand the basics of M&M propositions I and II

without taxes.

Modigliani and Miller's Capital-Structure Irrelevance Proposition

The M&M capital-structure irrelevance proposition assumes no taxes and no

bankruptcy costs. In this simplified view, the weighted average cost of capital

(WACC) should remain constant with changes in the company's capital structure. For

example, no matter how the firm borrows, there will be no tax benefit from interest

payments and thus no changes or benefits to the WACC. Additionally, since there are

no changes or benefits from increases in debt, the capital structure does not influence

a company's stock price, and the capital structure is therefore irrelevant to a

company's stock price.

However, as we have stated, taxes and bankruptcy costs do significantly affect a

company's stock price. In additional papers, Modigliani and Miller included both the

effect of taxes and bankruptcy costs.

Modigliani and Miller's Tradeoff Theory of Leverage

The tradeoff theory assumes that there are benefits to leverage within a capital

structure up until the optimal capital structure is reached. The theory recognizes the

tax benefit from interest payments - that is, because interest paid on debt is tax

deductible, issuing bonds effectively reduces a company's tax liability. Paying

dividends on equity, however, does not. Thought of another way, the actual rate of

interest companies pay on the bonds they issue is less than the nominal rate of interest

because of the tax savings. Studies suggest, however, that most companies have less

leverage than this theory would suggest is optimal.

In comparing the two theories, the main difference between them is the potential

benefit from debt in a capital structure, which comes from the tax benefit of the

interest payments. Since the MM capital-structure irrelevance theory assumes no

taxes, this benefit is not recognized, unlike the tradeoff theory of leverage, where

taxes, and thus the tax benefit of interest payments, are recognized.

In summary, the MM I theory without corporate taxes says that a firm's relative

proportions of debt and equity don't matter; MM I with corporate taxes says that the

firm with the greater proportion of debt is more valuable because of the interest tax

shield.

MM II deals with the WACC. It says that as the proportion of debt in the company's

capital structure increases, its return on equity to shareholders increases in a linear

fashion. The existence of higher debt levels makes investing in the company more

risky, so shareholders demand a higher risk premium on the company's stock.

However, because the company's capital structure is irrelevant, changes in the debt-

equity ratio do not affect WACC. MM II with corporate taxes acknowledges the

corporate tax savings from the interest tax deduction and thus concludes that changes

in the debt-equity ratio do affect WACC. Therefore, a greater proportion of debt

lowers the company's WACC.