Topic 12- Capital structure

Hi, How are you today?

Hi, How are you today?

Today, we're going to talk about Capital Structure and Miller and Modigliani's Propositions. Ever wondered what that means?

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First, let's talk about Capital Structure.

Capital structure refers to the way in which the company's assets are financed, the debt and equity mix.

Firms that are 100% equity firms are called_______?

Firms that have a mix of debt AND equity are called______?

Value of ​ (a)   = Value of Assets = Value of ​ (b)   + Value of ​ (c)  

• Firm
• Debt
• Equity.

Miller and Modigliani made 3 propositions in regard to capital structure and its effect on the firm. The original one was in 1985, based on assumptions that: (1) No taxes, (2) No bankruptcy costs, (3) Markets are perfectly efficient, and (4) Borrow costs do not differ between individuals and companies.

Then: (multiple correct answers)

• The value of the firm is independent of its capital structure

• The cost of equity of a levered firm = unlevered firm + risk premium

• WACC will be unaffected by the capital structure of the firm

Then, we know that these above assumptions were "unreal". Then, the M&M 1963 provided new assumptions:

(1) There are corporate taxes

and

(2) Debt interest is tax deductible.

Then we have the new 3 propositions!

• Firm value increases with leverage

• The cost of equity of a levered firm = unlevered firm + risk premium

  (However, les than no tax world)

• Advantage to leverage: the tax relief obtained on the debt interest

M&M Proposition II with taxes suggests that:

• The cost of equity increases with the use of debt.

• The cost of equity decreases with the use of debt.

• The cost of equity remains constant regardless of the use of debt.

According to Modigliani-Miller Proposition I with taxes, what happens to the cost of capital as the debt-equity ratio increases?

• Increases

• Decreases

• It depends

According to M&M Proposition II with taxes, what is the impact of an increase in personal tax rates on the cost of debt?

• Increases

• Decreases

• remains constant