Capital Structure: Modigliani and Miller Propositions, Trade-off and Pecking Order Theories, and Pra

Modigliani and Miller Propositions and Their Relevance to Capital Structure Decisions

1. Describe the two Modigliani and Miller propositions, the key assumptions under-lying them, and their relevance to capital structure decisions; use Proposition 2 to calculate the return on equity

2. Discuss the benefits and costs of using debt financing and calculate the value of the income tax benefit associated with debt Copyright© 2015 John Wiley & Sons, Inc. 

3. Describe the trade-off and pecking order theories of capital structure choice and explain what the empirical evidence tells us about these theories

4. Discuss some of the practical considerations that managers are concerned with when they choose a firm’s capital structure

• Interest tax shield benefit

• The perpetuity model assumes that:

• The firm will continue to be in business forever

• The firm will be able to realize the tax savings in the years in which the interest payments are made (the firm’s EBIT will always be at least as great as the interest expense)

• The firm’s tax rate will remain constant

 A firm’s capital structure is the mix of financial securities used to finance its activities.

 The mix will always include common stock and will often include debt and preferred stock.

 The firm may have several classes of common stock, for example, with different voting rights and, possibly, different claims on the cash flows
available to stockholders.

 The debt at a firm can be long term or short term, secured or unsecured, convertible or not convertible into common stock, and so on.

 Preferred stock can be cumulative or noncumulative and convertible or not convertible into common stock.

 The fraction of the total financing that is represented by debt is a measure of the financial leverage in the firm’s capital structure.

 A higher fraction of debt indicates a higher degree of financial leverage.

A. The amount of financial leverage in a firm’s capital structure is important because it affects the value of the firm.

A. The Optimal Capital Structure

 Managers at a firm choose a capital structure so that the mix of securities making up the capital structure minimizes the cost of financing the firm’s activities.

A. This mix is the optimal capital structure because the capital structure that minimizes the cost of financing the firm’s projects is also the capital structure that maximizes the total value of those projects and, therefore, the overall value of the firm.

B. The Modigliani and Miller Propositions

B. States that a firm’s capital structure decisions will have no effect on the value of the firm if

o (1) there are no taxes,

o (2) there are no information or transaction costs, and

o (3) the firm’s real investment policy is not affected by its capital structure decisions.

 The real investment policy of the firm includes the criteria that the firm uses in deciding which real assets (projects) to invest in.

C. The market value of the debt plus the market value of the equity must equal the value of the cash flows produced by the firm’s assets.