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. (Learn more
about corporate tax liability in How Big Corporations Avoid Big Tax Bills and Highest Corporate Tax Bills By
Sector.) 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 MMcapital-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.