Modigliani-Miller Formula

9 Key excerpts on "Modigliani-Miller Formula"

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  Corporate Finance

  Theory and Practice in Emerging Economies

  • Sunil Mahajan(Author)
  • 2020(Publication Date)
  • Cambridge University Press

    (Publisher)

  First, it can be explained in simple terms, even if its implications are wide ranging and transformative. Second, there are always stories—some apocryphal, many imaginary and a few true—pertaining to how these theories were formulated and discovered. The same applies to the MM theory of capital structure. Franco Modigliani and Merton Miller were both professors at the Carnegie Mellon University when they derived their theorem. They were asked to teach corporate finance despite the fact that they did not have any prior experience of the subject. They started looking for an optimal capital structure which would minimize the cost of capital. What they discovered, to their surprise, was that such an optimal structure did not exist and that there was no relationship between a company’s capital structure and its value/cost of capital. Capital Structure and Financing | 189 Financial Incentive Miller taught economic history and public finance at the Carnegie Mellon University (then Carnegie Tech). He was approached by the dean with an offer to teach corporate finance. Economics at that time was a highly snobbish department and Miller refused. The dean then dangled a carrot—business school salaries, at the time, were much higher than salaries at the Department of Economics. Miller’s wife had just delivered their second child and the couple was always short of money. He needed no further persuasion. The lure of the lucre can at times lead to noble, path-breaking outcomes! Interestingly, since Miller was young and relatively inexperienced, Modigliani was asked to keep an avuncular eye on him. The rest, as they say, is history. Academic literature also could not provide a satisfactory answer to the relationship between capital structure and value. The reading material that existed at the time was inconsistent. Dissatisfaction with the state of the subject led them to undertake their own research.

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  Corporate Finance

  Economic Foundations and Financial Modeling

  • Michelle R. Clayman, Martin S. Fridson, George H. Troughton, Michelle R. Clayman, Martin S. Fridson, George H. Troughton(Authors)
  • 2022(Publication Date)
  • Wiley

    (Publisher)

  158 The Corporation: Operating, Investing, and Financing Activities While these assumptions do not hold in practice—which ultimately does alter MM’s original conclusion of capital structure irrelevance—the MM theoretical framework remains a popular starting point for thinking about the strategic use of debt in a company’s capital structure. 4.1. MM Proposition I without Taxes: Capital Structure Irrelevance Given their assumptions, Modigliani and Miller proved that changing the capital structure does not affect firm value, in part because individual investors can create any capital structure they prefer for the company by borrowing and lending in their own accounts in addition to holding shares in the company. This “homemade” leverage argument relies on the MM assumption that investors can lend and borrow at the risk-free rate. Example: Suppose that a company has a capital structure consisting of 50% debt and 50% equity and that an individual investor would prefer that the company’s capital structure be 70% debt and 30% equity. The investor could borrow money to finance their share purchases so that their ownership of company assets would reflect their preferred 70% debt financing. This action would be equivalent to buying stock on margin and would have no effect on either the company’s expected operating cash flows or company value. Modigliani and Miller used the concept of arbitrage to demonstrate their point: If the value of an unlevered company (i.e., a company without any debt) is not equal to that of a levered company, investors could make a riskless arbitrage profit at no cost by selling shares of the overvalued company and using the proceeds to buy shares of the undervalued company, forcing their values to become equal. The value of a firm is thus determined not by the securities it issues but, rather, by its expected future cash flows.

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  Lectures on Corporate Finance

  • Peter Bossaerts, Bernt Arne Ødegaard(Authors)
  • 2006(Publication Date)
  • WSPC

    (Publisher)

  next chapter we will look at conditions that make that intuition break down. In particular we look at how taxes affect things.

  17.2 The Capital Structure Problem when Assets are In Place: Modigliani Miller I

  We will provide a clear answer to the capital structure problem under the assumption that the company's assets are already “in place”. By that we mean that investment took place and is irreversible. It can then be shown that the value of the firm does not depend on the debt/equity mix. Showing this is one of the most famous results in finance, the Modigliani Miller Theorem I (MM I).

  The main result can be stated as

  If we assume that the change in financing mix does not affect the total cash flows of the firm accruing to the shareholders and bondholders, changing the debt/equity ratio does not change V, the value of the firm.

  Intuitively, it can't possibly affect V, because “same cash flows implies same value.” Otherwise there would be an arbitrage opportunity (free lunch). In their original proof of the above proposition, Modigliani and Miller exploited the arbitrage opportunity in an ingenious way. We will go through their argument. Assume there are two firms, a levered one (one with both debt and equity), with value VL , and an unlevered one (one with only equity), with value VU Debt is perpetual, paying a coupon C per period. All cashflows are risk free, hence we can discount future coupon payments C at the risk free rate r to find the value of debt BL :

  Now let EL and EU denote the value of equity in the levered and unlevered firm, respectively. Of course, EU = VU . For simplicity, suppose both firms earn a perpetual stream of F dollars per period. The levered firm pays C out of F and passes the remainder, F — C, to the shareholders. The unlevered firm passes on the entire flow F to shareholders. If the debt equity mix does not affect firm value, VU = VL

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  Short Introduction to Corporate Finance

  • Raghavendra Rau(Author)
  • 2016(Publication Date)
  • Cambridge University Press

    (Publisher)

  They do something with the cash – they invest it in some kind of asset. If the asset has a negative NPV, however, the initial announcement of the debt issue will be greeted with a negative return – but the market will be react-ing to the investment, not to the issue of debt. Modigliani and Miller’s fundamental insight was to decouple the firm’s invest-ment decision from its financing decision. 1 Modigliani and Miller started by making some simplifying assumptions. They assumed that markets are efficient, everyone has symmetric information, buyers and sellers cannot influence the price by trading the asset (the market is perfectly competi-tive), there are no transaction costs, no taxes (either personal or corporate), and no lawyers (no bankruptcy costs). After mak-ing all these assumptions (in admittedly an ideal world), they embarked on a thought experiment. Specifically, they considered only firms where the firm issued debt but then used that money to buy back shares. Or the firm issued equity and then used that money to retire its debt. In either of these two cases, the assets side of the balance sheet is untouched. So if the firm’s value changed, it could only be from the direct effects of issuing or retiring debt. In the actual thought experiment, they defined a number of terms. These were as follows: 1. The value of an all-equity financed firm is V U (which was equal to E U , the value of its equity). U stands for unlevered: that is, a firm with no debt. Capital Structure in Perfect and Efficient Capital Markets 73 2. A firm with identical assets 2 but partially financed with debt, D L and equity E L has the value V L (where L stands for Levered). The weight of debt in the total amount of firm liabilities is therefore given by D L /V L (or D/V for short), and the weight of equity is E/V = 1 − D/V. 3. The corporate borrowing rate is r D . 4. The expected return on equity (the cost of equity) is r E .

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  Fisher Model And Financial Markets, The

  • Richard D Macminn(Author)
  • 2005(Publication Date)
  • World Scientific

    (Publisher)

  This interpretation leads to the observation that value can only be created by the corporation if it can provide the investor with an asset or cash flow that cannot be readily duplicated on personal account. Hence, the 1958 Modigliani–Miller Theorem applies to a much wider set of decisions than those the authors may have originally envisioned. The theorem not only makes capital structure irrelevant but it also makes risk management irrelevant, i.e., at least within the ceteris paribus conditions of the theorem. A few examples of a generalized theorem are considered here. The first is concerned with hedging in financial markets. 3 Here we show that the value 3 Hedging in commodity markets might also be considered. See Holthausen, D (1979). “Hedging and the Competitive Firm Under Price Uncertainty.” American Economic Review 69 : 989–995, Feder, G. et al. (1980). “Futures Market and the Theory of the Firm Under Price Uncertainty.” Quarterly Journal of Economics XCIV : 317–328. These are models of risk averse agents making decisions without recourse to any diversification on personal account and no distinction between personal and corporate account. The corporate form is considered in MacMinn, R. D. (1987). “Forward Markets, Stock Markets, and the Theory of the Firm.” Journal of Finance 42 (5): 1167–1185, and hedging in commodity markets is shown to have an impact on value through the preservation of tax credits. 88 The Fisher Model and Financial Markets CHAPTER 9 of the hedged firm equals that of the unhedged firm. Next, we consider two insurance examples and show that the value of the insured firm equals that of the uninsured firm. Forward markets Consider a forward contract. Let denote the unit payoff on a stock index contract and let f denote the forward price. Suppose the unit payoff is increas-ing in state ξ . The payoff on a forward position is ϕ ( f − ( ξ )), where ϕ is the position taken by the firm in futures.

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  Essentials of Corporate Finance

  • Robert Parrino, David S. Kidwell, Thomas Bates(Authors)
  • 2013(Publication Date)
  • Wiley

    (Publisher)

  From the discussion of the finance balance sheet in Chapter 11, we know that the market value of the debt plus the market value of the equity must equal the market value of the cash flows produced by the firm’s assets (V Assets ). In practice, we also refer to V Assets as the firm value or the firm’s enterprise value (V Firm ), which means that we can write Equation 11.1 as: V Firm 5 V Assets 5 V Debt 1 V Equity (14.1) M&M Proposition 1 says that if the size of the pie (representing the present value of the free cash flows the firm’s assets are expected to produce in the future) is fixed, and no one other than the stock- holders and the debt holders is getting a slice of the pie, then the combined value of the equity and debt claims does not change when you change the capital structure. You can see this in Exhibit 14.1, where each of the three pies represents a different capital structure. No matter how you slice the pie, the total value of the debt plus the equity remains the same. real investment policy the policy relating to the criteria the firm uses in deciding which real assets (projects) to invest in firm value, or enterprise value the total value of the firm’s assets; it equals the value of the equity financing plus the value of the debt financing used by the firm 2 The Nobel Prize Committee cited the M&M propositions when it awarded Nobel Prizes in Economics to Professor Modigliani in 1985 and to Professor Miller in 1990. THE OPTIMAL CAPITAL STRUCTURE MINIMIZES THE COST OF FINANCING A FIRM’S ACTIVITIES The optimal capital structure for a firm is the capital structure that minimizes the overall cost of financing the firm’s portfolio of projects. Minimizing the over- all cost of financing the firm’s projects maximizes the value of the firm’s free cash flows.

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  2024 CFA Program Curriculum Level I Box Set

  • (Author)
  • 2023(Publication Date)
  • Wiley

    (Publisher)

  Issuers generally aim to minimize their weighted-average cost of capital and to match the duration of their assets and financing. Managements’ target capital structures are usually stated using book values or indirectly through financial leverage ratios, such as a maximum ratio of debt or net debt to EBITDA or a minimum credit rating.
• While management has some influence, the total amount and type of financing needed or the weights in the WACC calculation often depends on the issuer’s business model (e.g., capital intensive or capital light) and on the company’s life cycle stage.
• The component costs of debt and equity are determined by top-down factors, such as financial market and industry conditions, and by issuer-specific factors, including the stability of revenues and operating and financial leverage.
• Modigliani and Miller (MM) showed, under a restrictive set of assumptions including no taxes, that an issuer’s capital structure is irrelevant to firm value. MM relaxed the assumptions by considering corporate taxes, financial distress, and bankruptcy costs and showed that capital structure does matter, although far less than an issuer’s future cash flows, for firm value.
• Under MM’s static trade-off theory of capital structure, the optimal capital structure occurs where the tax benefit of debt equals the financial distress costs associated with debt.
• The pecking order theory of capital structure is an alternative to the static theory and suggests that a firm will use internal financing as much as possible. If external financing is needed, the firm prefers private debt over public debt and will limit the use of equity financing if possible.