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Modigliani & Miller (M&M Propositions I & II) - Capital Structure of Corporations 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) If you recall the tutorial on Weighted Average Cost of Capital (WACC), the formula for WACC is:
The WACC formula can be manipulated and written in another form:
The above formula can also be rewritten as:
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).
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