Capital Structure : Modigliani and Merton Miller(M&M)

We know that the best capital structure for a corporation is when the WACC is minimized. This is partly derived From two famous Nobel prize winners, Franco Modigliani and Merton Miller who developed the M&M Propositions I,II,IIIand IV.


M&M Proposition I


M&M Proposition I states that the value of a firm does NOT depend on its capital structure. For example, think of 2 firms that have the same business operations, and same kind of assets. thus, the left side of their Balance Sheets look exactly the same. The only thing different between the 2 firms is the right side of the balance sheet, i.e the liabilities and how they finance their business activities.
     If a firm'sstocks make up 70% of The capital structure while bonds (debt) make up for 30%.In other firm it is the exact opposite. This is the case because the Assets of both capital structures are the exactly same.

M&M Proposition 1 therefore says how the debt and equity is structured in a corporation is Irrelevant. The value of the firm is determined by Real Assets and not its capital structure.

M&M Proposition II

    M&M Proposition II states that the Value of the firm depends on three things:

1) Required rate of return on the firm's Assets (Ra)
2) Cost of debt of the firm (Rd)
3) Debt/Equity ratio of the firm (D/E)

The WACC formula can be manipulated and written in another form:

Ra = (E/V) x Re + (D/V) x d

The above formula can also be rewritten as

Re = Ra + (Ra - Rd) x D/E)

This formula  is what M&M Proposition I is all about.

As Debt/Equity Ratio Increases -> Re will Increase (upwards sloping).

This is the basic identity of M&M Proposition I and II, that the capital structure of the firm does not affect its total value.

- WACC therefore remains the same even if the company borrows more debt (and increases its Debt/Equity ratio). 

·     M-M proposition 3:the distribution of dividends does not change the firm’s market value: it only changes the mix of E and D in the financing of the firm.

·     M-M proposition 4: in order to decide an investment, a firm should expect a rate of return at least equal to r_a, no matter where the finance would come from. This means that the marginal cost of capital should be equal to the average one. The constant r_a is sometimes called the “hurdle rate” (the rate required for capital investment).