EFN507 Chap.9 Modigliani and Miller: Does Capital Structure Matter?
Modigliani and Miller: Does Capital Structure Matter?
The irrelevance benchmark
Week 7 starts from Modigliani and Miller (1958): in perfect, frictionless capital markets the mix of debt and equity does not change the value of the firm or its overall cost of capital. Investors can create or undo leverage on their own account, so they will not pay a firm to do it.
Proposition II follows: the cost of equity rises in a straight line with the debt-to-equity ratio so that the weighted average stays fixed, and equity beta rises in the same way.
Relaxing the assumptions
The tutorials apply this to repurchases, debt ratios, earnings per share and price-earnings ratios, and show how new debt can transfer wealth from existing bondholders to shareholders.
Adding corporate tax gives VL = VU + tD, and Myers's reading frames the chapters that follow: taxes, information and agency are the reasons financing matters.
What this chapter covers
- 01
Perfect-market assumptions behind irrelevance
- 02
Homemade leverage and why it removes any premium
- 03
Proposition II for returns and for betas
- 04
Repurchases, earnings per share and price-earnings ratios
- 05
Wealth transfers from existing bondholders
- 06
Proposition I with corporate tax
Worked example · free
Cost of equity after a debt-financed buyback
- +1Firm value stays $200m, so equity falls to 200 − 80 = $120m.
- +2Cost of equity = 15% + (15% − 6%) × 80 ÷ 120 = 21%.
- +1Check: equity earns 30 − 0.06 × 80 = $25.2m, and 25.2 ÷ 120 = 21%.
- +1Earnings per share rise, but so does risk, so the market capitalises them at the higher 21% and the price is unchanged.
Key terms
- Homemade leverage
- An investor borrowing or lending on personal account to recreate or undo a firm's borrowing.
- Proposition I
- Modigliani and Miller's result that firm value does not depend on capital structure in perfect markets.
- Proposition II
- The result that the cost of equity rises linearly with the debt-to-equity ratio, keeping the overall cost of capital constant.
- Wealth transfer
- A gain to one class of investor that comes from a loss to another, with firm value unchanged.
Modigliani and Miller: Does Capital Structure Matter? FAQ
Why can't a firm create value just by borrowing in perfect markets?
Because investors can borrow on the same terms themselves. If a levered firm traded at a premium, investors would buy the unlevered firm and borrow personally to copy the payoff more cheaply, driving the premium away.
If debt is cheaper than equity, why doesn't the WACC fall?
Each dollar of debt makes the remaining equity riskier, so its required return rises. Proposition II shows the rise exactly offsets the cheaper debt, leaving the weighted average equal to the return on the firm's assets.
Why does earnings per share rise after a leveraged buyback?
Fewer shares share the earnings left after interest. The price does not rise, though, because each share now carries more financial risk and the market discounts its earnings at a higher rate; the price-earnings ratio falls.
How can new debt hurt existing bondholders?
Extra borrowing makes default more likely, so the market value of existing bonds falls. With firm value fixed, that loss reappears as a gain to shareholders, which is why lenders insist on covenants restricting new debt.
What changes when corporate tax is added?
Interest is deductible, so borrowing reduces the government's share of the cash flows. With permanent debt the levered firm is worth the unlevered firm plus the tax rate times the debt, and the after-tax WACC falls as leverage rises.
Why study a theory whose assumptions never hold?
Because it tells you where to look. Myers notes the logic is widely accepted, and every reason financing matters, such as taxes, information gaps and agency costs, is a broken assumption of the theorem.
Exam move
Draw Proposition II with numbers from one example, then rework a debt-financed buyback with and without tax, reporting firm value, equity value, cost of equity and earnings per share each time.
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