If you read the chapter on Weighted
Average Cost of Capital (WACC), you know that the
best capital structure for a corporation is when the WACC
is minimized. This is partly derived from two famous Nobel
prize winners, Franco Modigliani and Merton Miller who
developed the M&M Propositions I and II.
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).
