Exploring Capital Structure Theories | CFA Level I Corporate Issuers

Today, we’ll delve into the world of capital structure decisions by understanding three key theories: MM 1958, MM 1963, and the static trade-off theory.

Understanding Capital Structure Theories

We’ll be discussing three essential theories:

• MM 1958: Assumes no taxes and no costs of financial distress.
• MM 1963: Considers taxes but not costs of financial distress.
• Static Trade-Off Theory: Takes into account both taxes and costs of financial distress.

You might be wondering why we bother with MM theories if they don’t perfectly align with reality. Don’t worry; it’ll all become clear soon. For now, remember that MM theories lay the groundwork for understanding the relationship between capital structure, taxes, and the cost of capital. This knowledge is crucial for comprehending the static trade-off theory, which offers a realistic explanation for the link between capital structure and firm value.

MM Proposition with No Taxes (MM 1958)

Published in 1958 by Professors Modigliani and Miller (hence the MM acronym), this theory features two propositions:

Proposition 1: Capital Structure is Irrelevant

In a perfect world with no taxes, capital structure doesn’t matter. This perfect world assumes:

• Perfectly competitive capital markets with no transaction costs, taxes, or bankruptcy costs.
• Homogeneous investor expectations.
• Riskless borrowing and lending.
• No agency costs.
• Investment decisions are unaffected by financing decisions.

Given these assumptions, MM argues that a firm’s value remains the same, regardless of capital structure.

Proposition 2: Cost of Capital and Degree of Leverage

Under the same perfect market assumptions, MM explains that the cost of debt must be lower than the cost of equity. However, as a company increases its debt usage, equityholders’ risk rises, which in turn increases the cost of equity. According to MM, the weighted average cost of capital (WACC) remains constant as leverage increases.

MM Proposition with Taxes (MM 1963)

When we remove the no-tax assumption, the value of the firm is maximized at 100% debt. Let’s explore how this conclusion is justified.

Proposition 1: Tax Shield Benefits

Interest payments are tax-deductible, while dividends are not. Therefore, a leveraged firm paying interest to debt holders will have a higher after-tax operating cash flow than a firm only paying dividends. This difference is called the tax shield, which adds to the company’s value.

Under this proposition, the firm’s value is maximized when debt is maximized.

Proposition 2: Cost of Capital and Degree of Leverage with Taxes

Just like the first proposition, this theory supports the idea that value is maximized at 100% debt. When taxes are considered, the tax shield provided by debt causes the WACC to decline as leverage increases. At 100% debt, the WACC is minimized, maximizing the firm’s value.

Conclusion: Comparing MM Propositions

Let’s recap the key takeaways from both MM propositions:

MM 1958 (No Taxes)

• Capital structure is irrelevant.
• Proposition 1: The value of a leveraged firm should be the same as the value of an unleveraged firm.
• Proposition 2: The increase in the cost of equity will completely offset the lower cost of debt when leverage increases.

MM 1963 (With Taxes)

• Value is maximized at 100% debt.
• Proposition 1: The value of a leveraged firm increases as leverage increases, due to the tax shield.
• Proposition 2: The increase in the cost of equity is reduced by the tax shield, leading to the WACC being minimized at 100% debt.

With these foundations in place, we’re ready to tackle the static trade-off theory in our next lesson.