MODIGLIANI – MILLER THEOREM ANASTASIIA TISETSKA

AGENDA:  MODIGLIANI–MILLER I – LEVERAGE, ARBITRAGE AND FIRM VALUE  MODIGLIANI–MILLER II – LEVERAGE, RISK AND COST OF CAPITAL  IS DEBT BETTER THAN EQUITY?  NOBEL PRIZE

 Modigliani – Miller theorem is used in financial and economic studies to analyze the value of a firm. It states that a firm’s value is based on its ability to earn revenue plus the risk of its underlying assets. It is independent of the way it chooses to finance its investments or distribute dividends.

 M&M Theorem holds only if: Markets are completely efficient There are no cost for bankruptcy or agency dynamics There are no taxes  The basic idea is that, under certain assumptions, it makes no difference whether a firm finances itself with debt or equity.

 Modigliani-Miller I: Leverage, Arbitrage, and Firm Value  Leverage is the use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment. The amount of debt used to finance a firm's assets. A firm with significantly more debt than equity is considered to be highly leveraged.  Arbitrage is basically buying in one market and simultaneously selling in another, profiting from a temporary difference. This is considered riskless profit for the investor/trader.  Firm value, or Enterprise Value, is a measure of a company's total value, often used as a more comprehensive alternative to equity market capitalization.

 Modigliani-Miller I: Leverage, Arbitrage, and Firm Value Modigliani and Miller showed that their capital structure propositions below hold in a perfect capital market, which is a market with the following set of conditions: 1.Investors and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows. 2.There are no taxes, transaction costs, or issuance costs associated with security trading. 3.A firm’s financing decisions do not change the cash flows generated by its investments nor do they reveal new information about them.

 M&M Proposition I In a perfect capital market, the total value of a firm is equal to the market value of the total cash flows generated by its assets and is not affected by its choice of capital structure. V L = D L + E L

 Modigliani-Miller II: Leverage, Risk, and the Cost of Capital  Risk is the chance that an investment's actual return will be different than expected. Risk includes the possibility of losing some or all of the original investment.  Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is proportionately weighted.

 Modigliani-Miller II: Leverage, Risk, and the Cost of Capital

 M&M Proposition II

Proposition II with risky debt. As leverage (D/E) increases, the WACC (k0) stays constant. A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt. The formula is derived from the theory of weighted average cost of capital (WACC). These propositions are true under the following assumptions:  no transaction costs exist  individuals and corporations borrow at the same rates. These results might seem irrelevant (after all, none of the conditions are met in the real world), but the theorem is still taught and studied because it tells something very important. That is, capital structure matters precisely because one or more of these assumptions is violated. It tells where to look for determinants of optimal capital structure and how those factors might affect optimal capital structure.

 Is Debt Better than Equity? M&M Theorem demonstrates that in the world with taxes a company that uses some amount of debt financing will be more valuable than its equal counterpart that finances itself with equity only. The reason for that is the tax advantage of deducting the interest payments on the debt, thus lowering the debt-laden company’s tax liability makes it more profitable than the equity-only company. Being more profitable makes the debt-laden company more valuable.

 Is Debt Better than Equity? Example:  You run a small business and need $40,000 of financing. You can either take out a $40,000 bank loan at a 10% interest rate or you can sell a 25% stake of your business to your neighbor for $40,000. Suppose your business earns $20,000 of profit during the next year.  If you took the bank loan, your interest expense (cost of debt financing) would be $4,000, leaving you with $16,000 in profit.  Conversely, if you had used equity financing, you would have zero debt (and thus no interest expense), but would keep only 75% of your profit (the other 25% being owned by your neighbor). Thus, your personal profit would only be $15,000 (75% x $20,000). From this example, you can see how it is less expensive for you, as the original shareholder of your company, to issue debt as opposed to equity. Taxes make the situation even better if you had debt, since interest expense is deducted from earnings before income taxes are levied, thus acting as a tax shield.

Merton Howard Miller (May 16, 1923 – June 3, 2000) Franco Modigliani (June 18, 1918 – September 25, 2003)

Modigliani and Miller won Nobel prizes in economics in 1985 and 1990, respectively, in part for their contributions to what are often referred to as the capital structure irrelevance and dividend irrelevance theorems.

Thank you for your attention!