Capital
Capital Structure
Structure
Theories
Theories
MM Model
• Franco Modigliani and Merton Miller (1958)
addressed capital structure in a rigorous and
scientific fashion.
• Assumptions:
– No personal or corporate tax
– Homogeneous risk class
– Homogeneous expectations
– Perfect capital market
– Debt of firms and individuals is riskless
– Cash flows are perpetuities
MM without Taxes:
Proposition I
• The value of any firm is established by capitalizing
its expected net operating income (EBIT) at a
constant rate (ksU) which is based on the firm’s
risk class:
EBIT EBIT
VL VU
WACC k sU
• Both the firms are in the same risk class. Under
the MM model, when there are no taxes, the value
of the firm is independent of its leverage.
MM without Taxes: Proposition II
• The cost of equity to a levered firm, ksL, is equal to (i) the
cost of equity to an unlevered firm in the same risk class,
ksU, plus (ii) a risk premium whose size depends on both the
differential between an unlevered firm’s costs of debt and
equity and the amount of debt used:
D
k sL k sU Risk Premium k sU (k sU - kd )
S
• This equation states that as the firm’s use of debt
increases, its cost of equity also rises, and in a
mathematically precise manner.
MM without Taxes
• Taken together the two propositions imply that
– The inclusion of the more debt in the capital structure
will not increase the value of the firm, because the
benefits of cheaper debt will be exactly offset by an
increase in the riskiness, hence in the cost of equity. .
– MM argue that in a world without taxes, both the value
of a firm and its WACC would be unaffected by its
capital structure.
MM with Corporate Taxes
• Though the original work of MM ignored
taxes, their later work (1963) considered
taxes. MM concluded that the value of
firm will increase in using more leverage
because interest is tax deductible
expense; hence more of the leveraged
firm’s operating income flows through to
the investors.
MM with Corporate Taxes
Proposition I
• The value of a levered firm is equal to the
value of the unlevered firm in the same
risk class plus the gain from leverage. The
gain from leverage is the value of tax
savings (corporate tax, T * the amount of
debt of the firm, D):
VL = VU + TD
MM with Corporate Taxes
Proposition II
• The cost of equity of a levered firm is equal to
– (i) the cost of equity to an unlevered firm in the same
risk class plus
– (ii) a risk premium whose size depends on the
differential between the costs of equity and debt to an
unlevered firm, the amount of financial leverage used,
and the corporate tax rate:
D
k sL k sU (k sU k d )(1 T )
S
The Hamada Model:
Introducing Market Risk
• Robert Hamada combined the Capital Asset Pricing Model (CAPM)
with the MM after-tax model to obtain the expression for ksL,
the cost of equity to a leveraged firm:
• ksL = Risk-free rate + Business risk premium + Financial risk
premium
• ksL = kRF + [kM – kRF]bU + [kM – kRF]bU (1-T)[D/S]
• The firm would have the beta coefficient “bU” if it used no
financial leverage. The required rate of return consists of three
components: kRF, risk-free rate, which compensates the
shareholders for the time value of money; a premium for business
risk as reflected by the term [kM – kRF]bU ; and a premium for
financial risk as reflected by the term [kM – kRF]bU (1-T)[D/S].
If the firm has no financial leverage, i.e., D = 0, then the financial
risk premium term would be zero and the equity investors would be
compensated only for business risk.
The Miller Model:
• In the presidential address to the
American Finance Association,
Merton Miller introduced a model
designed to show how leverage
affects firms’ values when both
personal and corporate taxes are
taken into account.
The Miller Model
• Having the same assumptions of MM
and including personal taxes, the
value of unlevered firm is found as:
EBIT (1 Tc )(1 Ts )
VU
k sU
The Miller Model
• Cash flow of levered firm
= Net CF to shareholders + Net CF to bondholders
CFL = (EBIT - I) (1 - Tc) (1 - Ts) + I (1 –Td)
Where, I is the annual interest payment.
So, CFL = [EBIT (1 - Tc) (1 - Ts)] - [I (1 - Tc) (1 -
Ts)] + I (1 – Td)
The Miller Model
• As we know that the value of firm is:
CF / k, so,
EBIT (1 - Tc) (1 - Ts) I (1 - Tc) (1 - Ts) I (1 Td)
VL
k sU kd kd
I (1 Td ) (1 Tc )(1 Ts )
VL VU 1
kd (1 Td )
The Miller Model
• As we also know that the market
value of debt, D, is: I(1-Td)/kd.
Substituting ‘D’ into the preceding
equation and rearranging, we obtain
the Miller Model:
(1 Tc )(1 Ts )
• Miller Model: VL VU 1 (1 T ) D
d
Trade-off Model
PV of expected PV of
VL VU TD costs of financial agency
distress costs
The Signaling Model
• Professor Gordon Donaldson of Harvard
conducted an extensive study of how
corporations actually establish their capital
structures.
– Firms prefer to finance with internally generated funds
– Firms set target dividend payout ratios based on
expected future investment opportunities and
expected future cash flows.
– Dividends are ‘sticky’ in the short run – firms are
reluctant to raise dividends unless they are confident
that the higher dividend can be maintained, and they
are especially reluctant to cut the dividend.
