Corporate Finance

Corporate Finance

Modigliani and Miller's Propositions I and II with corporate taxes

M&M Proposition I

M&M Proposition I states that the value of a firm does NOT depend on its capital structure. For example, think of 2 firms that have the same business operations, and same kind of assets. Thus, the left side of their Balance Sheets look exactly the same. The only thing different between the 2 firms is the right side of the balance sheet, i.e the liabilities and how they finance their business activities.

In the first diagram, stocks make up 70% of the capital structure while bonds (debt) make up for 30%. In the second diagram, it is the exact opposite. This is the case because the assets of both capital structures are the exactly same.

M&M Proposition 1 therefore says how the debt and equity is structured in a corporation is irrelevant. The value of the firm is determined by Real Assets and not its capital structure.

M&M Proposition II

M&M Proposition II states that the value of the firm depends on three things:

1) Required rate of return on the firm's assets (Ra)2) Cost of debt of the firm (Rd)3) Debt/Equity ratio of the firm (D/E)

If you recall the tutorial on Weighted Average Cost of Capital (WACC), the formula for WACC is:

WACC = [Rd x D/V x (1-5)] + [Re x E/V]

 

The WACC formula can be manipulated and written in another form:

Ra = (E/V) x Re + (D/V) x Rd

 

The above formula can also be rewritten as:

Re = Ra + (Ra - Rd) x (D/E)

 

This formula #3 is what M&M Proposition II is all about.

Analysis of M&M Proposition II Graph

- The above graph tells us that the Required Rate of Return on the firm (Re) is a linear straight line with a slope of (Ra - Rd)

- Why is Re linear curved and upwards sloping? This is because as a company borrows more debt (and increases its Debt/Equity ratio), the risk of bankruptcy is even more higher. Since adding more debt is risky, the shareholders demand a higher rate of return (Re) from the firm's business operations. This is why Re is upwards sloping:

- As Debt/Equity Ratio Increases -> Re will Increase (upwards sloping).

- Notice that the Weighted Average Cost of Capital (WACC) in the graph is a straight line with NO slope. It therefore does not have any relationship with the Debt/Equity ratio. This is the basic identity of M&M Proposition I and II, that the capital structure of the firm does not affect its total value.

- WACC therefore remains the same even if the company borrows more debt (and increases its Debt/Equity ratio).

Residual Dividend Policy

Arguments Against Dividends

First, some financial analysts feel that the consideration of a dividend policy is irrelevant because investors have the ability to create "homemade" dividends. These analysts claim that this income is achieved by individuals adjusting their personal portfolios to reflect their own preferences. For example, investors looking for a steady stream of income are more likely to invest in bonds (in which interest payments ...