Modigliani Miller Theorem Summary of Chapter 14 The basic sources of long term financing are Long Term Debt Common Stock Preferred Stock Common shareholders have voting rights limited liability and a residual claim on the corporation Bondholders have a contractual claim against the corporation Preferred stock has some of the features of debt and equity Firms need financing most of it is generated internally The Long Term Financial Gap Uses of Cash Flow 100 Sources of Cash Flow 100 Capital spending Internal cash flow retained earnings plus depreciation 68 3 Net working capital plus other uses Internal cash flow Financial deficit Long term debt and equity 31 7 External cash flow 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 6 26 5 51 5 95 5 59 6 71 9 43 10 93 12 16 12 36 17 26 20 00 19 28 14 70 46 92 48 38 50 67 50 45 50 81 45 33 42 57 40 71 48 36 46 30 46 16 44 59 46 04 22 88 24 38 23 82 26 80 29 15 29 47 31 20 32 24 28 18 21 86 25 56 26 76 26 57 24 04 21 46 19 70 17 07 13 33 15 67 15 28 14 92 10 95 14 57 8 22 9 82 12 75 Will the capital structure Affect The value of the firm Modigliani Miller Theorem Assumptions There are no transactions costs for buying and selling securities and there are no bid ask spreads The capital market is perfectly competitive firms and investors are all price takers There are no bankruptcy costs There are no corporate or personal taxes All agents firms and investors have the same information Then The value of the firm is independent of its capital structure Financing choices are irrelevant Pie theory In general financial transactions don t create or destroy value as long as securities are sold at fair value Unless they affect taxes investment decisions etc Value is created on the left hand side of the balance sheet not the right hand side Your firm needs to raise 100 million Does it matter whether you decide to issue debt or equity Leverage increases ROE and the expected returns to stockholders but it also increases risk According to M M the two effects offset each other exactly The MM Propositions I II No Taxes Proposition I Firm value is not affected by leverage V L VU Proposition II Leverage increases the risk and return to stockholders rs r0 B SL r0 rB rB is the interest rate cost of debt rs is the return on levered equity cost of equity r0 is the return on unlevered equity cost of capital B is the value of debt SL is the value of levered equity The MM Proposition I No Taxes The derivation is straightforward Shareholders in a levered firm receive EBIT rB B Bondholders receive rB B Thus the total cash flow to all stakeholders is EBIT rB B rB B The present value of this stream of cash flows is VL Clearly EBIT rB B rB B EBIT The present value of this stream of cash flows is VU VL VU 15 4 The MM Proposition II No Taxes The derivation is straightforward rWACC B S rB rS B S B S B S rB rS r0 B S B S Then set rWACC r0 multiply both sides by B S B B S S B S rB rS r0 S B S S B S S B B S rB rS r0 S S B B rB rS r0 r0 S S B rS r0 r0 rB S B S S Cost of capital r The Cost of Equity the Cost of Debt and the Weighted Average Cost of Capital MM Proposition II with No Corporate Taxes r0 rS r0 rWACC B r0 rB SL B S rB rS B S B S rB rB Debt to equity Ratio B S Example Leverage and risk The required return and beta of equity goes up when leverage increases A E D and leverage WACC Leverage shifts the firm towards low cost debt financing but it also raises the cost of equity According to M M the two effects offset each other exactly Ignoring tax effects changing capital structure doesn t affect the WACC Without taxes Example Your firm is all equity financed and has 1 million of assets and 10 000 shares of stock stock price 100 Earnings before interest and taxes next year will be either 50 000 125 000 or 200 000 These earnings are expected to continue indefinitely The payout ratio is 100 The firm is thinking about a leverage recapitalization selling 300 000 of debt and using the proceeds to repurchase stock The interest rate is 10 How would this transaction affect the firm s EPS and stock price Ignore taxes No Arbitrage investors in U can replicate the cash flows of investors in L and vice versa Thus the prices of U and L must be same If VU VL Sell your holdings in firm U and buy a fraction of firm L s equity and debt If VU VL Sell your holdings in L buy a fraction of U s equity and borrow the amount D at an annual rate r Observations Firms follow a pecking order Different industries seem to have different target debt ratios Stock issues are bad news but debt issues are either neutral or good news Financing decisions Two models Pecking order theory Firms are worried primarily about selling undervalued shares They sell equity only when they have no other choice and there isn t a specific target debt ratio Trade off theory Firms care mostly about taxes and distress costs The tax benefits of debt dominate at low leverage while distress costs dominate at high leverage This trade off leads to an optimal capital structure Why is MM useful It tells us what is important Does debt affect investment decisions Does debt affect taxes Can equity be issued at fair value Are transaction costs or bankruptcy costs important And what isn t Impact of debt on ROE and risk Cost of debt relative to the cost of equity rD vs rE 15 5 Taxes The MM Propositions I II with Corporate Taxes Proposition I with Corporate Taxes Firm value increases with leverage VL VU TC B Proposition II with Corporate Taxes Some of the increase in equity risk and return is offset by interest tax shield rS r0 B S 1 TC r0 rB rB is the interest rate cost of debt rS is the return on equity cost of equity r0 is the return on unlevered equity cost of capital B is the value of debt S is the value of levered equity The MM Proposition I Corp Taxes Shareholders in a levered firm receive Bondholders receive EBIT rB B 1 TC rB B Thus the total cash flow to all stakeholders is EBIT rB B 1 TC rB B The present value of this stream of cash flows is VL Clearly EBIT rB B 1 TC rB B …