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A Small Note On MM Theory and APV

The document discusses Modigliani-Miller theory and its application to valuation using the APV method. Under MM theory, the value of a firm is unaffected by whether it uses debt or equity financing. However, when taxes are considered, debt financing provides a benefit in the form of an interest tax shield. The APV method values a firm as the net present value of its unlevered free cash flows plus the present value of the benefits from debt financing, such as tax shields, net of debt-related costs. The document provides equations for calculating levered cost of equity and beta under different capital structures. It also outlines the steps to estimate a firm's value using the APV method.

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Alisha Sharma
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50 views

A Small Note On MM Theory and APV

The document discusses Modigliani-Miller theory and its application to valuation using the APV method. Under MM theory, the value of a firm is unaffected by whether it uses debt or equity financing. However, when taxes are considered, debt financing provides a benefit in the form of an interest tax shield. The APV method values a firm as the net present value of its unlevered free cash flows plus the present value of the benefits from debt financing, such as tax shields, net of debt-related costs. The document provides equations for calculating levered cost of equity and beta under different capital structures. It also outlines the steps to estimate a firm's value using the APV method.

Uploaded by

Alisha Sharma
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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A small note on MM Theory, unlevering-relevering and APV1

The essence of MM theory on capital structure (irrelevance) is that under perfect


market conditions, Vu = VL i.e. when the operational (and asset size) risk is the same,
an unlevered firm (a firm with no debt) and a levered firm (a firm with some debt)
have the same value in some conditions. How a firm’s assets are funded have no
relevance in value creation.

The moment taxes factor into the situation, the levered firm is more valuable than the
unlevered firm (other conditions remaining same) i.e. V L = VU + PV of net debt benefits.
Tangible benefit of debt is ITS = Interest Tax Shield (firms that pay interest on debt
have reduced tax bill that retains as additional cash flow).

When a firm borrows, it either borrows with known debt value (in terms of currency)
or borrows with a debt to value ratio known. In both cases, the equations for risk and
returns are different. The following table provides the equations for various cases.

Discounting
Debt Policy Equation for Risk & Reward
rate for ITS
𝐷
𝑅 𝐸 = 𝑅𝐴 + × (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒) × (𝑅𝐴 − 𝑅 𝐷)
𝐸
Constant and 𝐷
𝛽𝐸 = 𝛽𝐴 + × (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒) × (𝛽𝐴 − 𝛽𝐷 ) RD
perpetual debt 𝐸

Constant and finite Estimate the ITS at each period because $


RD
debt debt is known but changes every period.
𝐷
𝑅 𝐸 = 𝑅𝐴 + × (𝑅𝐴 − 𝑅𝐷 )
𝐸
Fixed D/V (or D/E) 𝐷 RA
𝛽𝐸 = 𝛽𝐴 + × (𝛽𝐴 − 𝛽𝐷 )
𝐸

1
This note was prepared by Prof. Aravind Sampath as supplementary material in Corporate Finance course
APV

One of the applications of MM theory is in valuation, specifically in the APV method.

When MM theory is expanded to valuation, V L = VU + PVITS becomes

APV = NPVU + NPVF i.e. APV of a project (or firm) is the unlevered value of the project
(or firm) plus net effects of financing (PV ITS – PVdebtcosts) where debtcosts here includes
all non-interest based costs of debt.

To estimate APV, following estimations need to be done

1. Estimation of NPVU – for this you need after tax free cash flows and RA
2. Estimation of NPVF – for this you need to estimate ITS based-on scenario and
determine which discounting rate to use (RD or RA)

Appendix:

RA – unlevered cost of equity

RE – levered cost of equity

RD – pre-tax cost of debt

𝛽𝐸 – equity beta

𝛽𝐴 – asset beta

D – debt value (in ₹)


E – equity value (in ₹)

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