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?

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