Day 64 in MIT Sloan Fellows Class 2023, Managerial Finance 6, M&M and WACC
Modigliani and Miller Theories(M&M theory)
What Is the Modigliani-Miller (M&M) Theorem, and How Is It Used?
Merton Miller and Franco Modigliani conceptualized and developed this theorem, and published it in an article, "The Cost of Capital, Corporation Finance and the Theory of Investment," which appeared in the American Economic Review in the late 1950s.
In a nutshell, this article has some strong assumptions, and it basically argues there is no effect from capital structure change(D/E balance).
The assumptions are as follows.
- Perfect capital markets
- Homogenous risk classes
- No tax
- Full dividends payout
In this world, the only differentiation is cashflow from operation and capital structure does not give any difference in our strategy.
Cost of equity in M&M world
Think about the cost of capital.
In M&M world, it would be really simple because there is no tax.
If a company increased debt, Ru is still the same. The only variable to change is Re.
Hence, in MM world, increasing leverage has two opposing effects:
1) The share of less costly debt increases (lowering the unlevered cost of capital)
2) The cost of equity increases as the company becomes riskier (increasing the unlevered cost of capital)
Tax Shield and Cost of financial distress
However, in the real world, if you increase leverage, there are two effects.
- Tax shield
- Financial distress
These two factors makes Firm value in black line.
Blue line: only with tax shield effect.
Red line: MM world
WACC(Weighted-average-cost-of-capital)
Then, we consider cost of capital as a new discount rate.
(1-t) considers tax shield and we need to be careful about calculating CF to exclude interest payment.
