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Modigliani-Miller Theorem:
Capital Structure is irrellevant
What’s missing from the MM view?
- Taxes
Bankruptcy costs (costs of financial distress)
Incentive and information problems
Assumptions of Modiliani Miller for his Theorem
- Perfect capital markets (no taxes, no transaction costs, perfect information, etc.)
- Given investment program (operating decision)
How does debt affect the expected return on equity (ROE)?
The expected return on equity increases linearly in the firm‘s leverage (i.e., D/E, or debt-equity ratio).
Why can the following two statements both be true:
- Leverage has no benefit for investors (in a MM world)
- With increasing leverage, the expected ROE increases
Answer: The (systematic) equity risk increases at the same time!
Firm value = ?
equity market value + debt market value
MM exposes some fallacies
WACC fallacy: “cost of capital” for debt is lower than for equity (true), therefore more debt is better (false – ignores differences in risk).
EPS fallacy: debt-equity ratio effects EPS (true), so it should be chosen to maximize EPS (false – ignores effect on equity risk).
Total firm value consists of two parts:
- Value of the firm if 100% equity financed
- Tax savings from using debt
Costs incurred before bankruptcy, due to the perception that the firm is in financial trouble:
Customers stop buying product.
• Suppliers demand better terms.
• (The best) employees start to leave.
• Difficulties raising new capital. This is anticipated by competitors!
• Overall: For firm in financial distress, direct plus indirect bankruptcy costs may be substantial.
Risk is not simply an act of nature, Four problems to consider:
Risk-shifting problem (asset substitution)
Debt-overhang problem (underinvestment)
Adverse-selection problem (information asymmetry, underinvestment)
Free cash flow problem (discretion of management or soft budget constraint,
overinvestment)
Parts of Risk Control
reduced level of risky activity
loss prevention
loss reduction
Parts of Risk Financing
Retention / Self Insurance
insurance
Hedging
Other contractual risk-transfers
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Modigliani-Miller Theorem:
Capital Structure is irrellevant
What’s missing from the MM view?
- Taxes
Bankruptcy costs (costs of financial distress)
Incentive and information problems
Assumptions of Modiliani Miller for his Theorem
- Perfect capital markets (no taxes, no transaction costs, perfect information, etc.)
- Given investment program (operating decision)
How does debt affect the expected return on equity (ROE)?
The expected return on equity increases linearly in the firm‘s leverage (i.e., D/E, or debt-equity ratio).
Why can the following two statements both be true:
- Leverage has no benefit for investors (in a MM world)
- With increasing leverage, the expected ROE increases
Answer: The (systematic) equity risk increases at the same time!
Firm value = ?
equity market value + debt market value
MM exposes some fallacies
WACC fallacy: “cost of capital” for debt is lower than for equity (true), therefore more debt is better (false – ignores differences in risk).
EPS fallacy: debt-equity ratio effects EPS (true), so it should be chosen to maximize EPS (false – ignores effect on equity risk).
Total firm value consists of two parts:
- Value of the firm if 100% equity financed
- Tax savings from using debt
Costs incurred before bankruptcy, due to the perception that the firm is in financial trouble:
Customers stop buying product.
• Suppliers demand better terms.
• (The best) employees start to leave.
• Difficulties raising new capital. This is anticipated by competitors!
• Overall: For firm in financial distress, direct plus indirect bankruptcy costs may be substantial.
Risk is not simply an act of nature, Four problems to consider:
Risk-shifting problem (asset substitution)
Debt-overhang problem (underinvestment)
Adverse-selection problem (information asymmetry, underinvestment)
Free cash flow problem (discretion of management or soft budget constraint,
overinvestment)
Parts of Risk Control
reduced level of risky activity
loss prevention
loss reduction
Parts of Risk Financing
Retention / Self Insurance
insurance
Hedging
Other contractual risk-transfers
