Modigliani-Miller Theorems

MM Proposition 1 (No Taxes)

• Capital structure changes are independent of a firm's value.
• Increasing leverage raises the risk for investors, necessitating higher returns.
• High leverage can lead to financial distress and negative returns in declining markets.
• Firms carefully balance debt and equity to optimize returns while managing risk.
• Smaller amounts of debt are beneficial in a strong economy, compensating for increased risk with higher returns.
• Excessive debt can lead to significant losses in an economic downturn.
• Debt can provide tax benefits.
• Optimal leverage occurs where the present value of benefits equals the present value of costs.
• Debt's return bears no systematic risk, resulting in a zero-risk premium.
• Levered equity has higher systematic risk and risk premium than unlevered equity.
• Leverage increases equity risk, even without the risk of default.

MM Proposition 2 (No Taxes)

• Increasing debt raises the cost of equity.
• In perfect capital markets, a firm's weighted average cost of capital (WACC) is independent of its capital structure and equals the cost of unlevered equity.
• WACC remains constant as the capital structure changes.
• Risk distribution among stakeholders changes with shifts in the cost of equity and debt
• Cost of debt increases only with high leverage, as debtholders demand higher interest for protection.
• Cost of equity rises with leverage due to shareholders perceiving increased risk and demanding higher returns.
• WACC remains constant because the increased cost of equity offsets the benefits of cheaper debt.
• Debt is cheaper than equity; increased debt makes equity riskier, leading equity holders to demand higher returns.
• Levered equity's cost of capital equals unlevered equity's cost plus a premium proportional to the debt-equity ratio.
• An unlevered firm pays all asset-generated cash flows to equity holders.
• For a levered firm, project (Ra) is equal to the firm’s weighted average cost of capital.
• In perfect capital markets, WACC is independent of capital structure, equaling unlevered equity's cost of capital and matching the cost of assets.

Corporate Taxes & Interest Tax Shield

• Debt helps firms save on taxes due to the tax-deductibility of interest payments.
• A levered firm's cash flow includes a tax shield from deductible interest payments.
• MM Proposition 1 with corporate taxes states that a firm's value increases with debt due to tax savings.
• More debt leads to more tax savings, but excessive debt can cause financial distress.
• An interest tax shield equals the tax savings from deductible interest payments.
• Leveraged firms can benefit, but excessive debt isn't necessarily beneficial.

MM1 with Corporate Taxes

• The value of a levered firm exceeds that of an unlevered firm due to the present value of tax savings from debt.

The Tax Shield with Permanent Debt

• Future interest payments are uncertain due to changes in the marginal tax rate, outstanding debt, interest rates, and firm risk.
• Assuming that debt D is borrowed and kept permanently, then the interest tax shield is Tc × Rf × D.

WACC with Corporate Taxes

• The effective after-tax borrowing rate is Rd(1 − Tc).
• The weighted average cost of capital (WACC) becomes lower when more debt is raised.

Firm's with no Debt

• Some firms are fully equity-financed due to better operating performance.
• Equity holders anticipate greater earning potential.
• Debt holders don't charge high costs due to the low probability of liquidation.

Including Personal Taxes in the Interest Tax Shield

• The amount an investor is willing to pay for a security depends on the cash flows they will receive after all taxes have been paid.
• Personal taxes reduce cash flows to investors, offsetting some corporate tax benefits of leverage.
• If Operating Income is paid to bondholders then there is no Corporate Tax. They will then need to pay personal tax (Tp).
• If Operating Income is paid to stockholders then they will pay corporate tax (100% unlevered firm).
• Taxes (TpE ) are calculated based on $1, rather (1 - Tc), because they will receive imputation credits and don't have to pay corporate tax.
• Bondholders pay personal tax (Tpd) on interest income; equity holders pay personal tax (Tpe) on dividends.
• If Tpd > Tpe --> Equity becomes more attractive than debt.

Relative Advantage Formula (RAF)

• When RAF < 1, the company has a relative advantage in raising debt and should raise more debt (VL > VU or tax shield benefit).
• When RAF > 1, the company has a relative advantage in equity financing and should cut down debt financing. (levered firm's value is lower than an unlevered firm or tax shield benefit is negative).
• The optimal level of debt financing is where RAF = 1, maximizing tax shield benefits.

Debt and Taxes – Miller 1977

• In equilibrium, no individual firm can gain or lose by changing its debt-to-equity (D/E) ratio.
• There is no optimal (D/E) ratio for any firm, and the market is interested in the total amount of debt.
• The conditions depend on Tpe < Tpd which must be low enough to offset Tc shield and future profits
• Capital structure changes occur only when Tpd and Tc change.
• The maximum cost of debt a company can afford is Rd = Re / (1 - Tc).
• The investor debt depends on the return Rd = Required rate of Return / (1-Tpd).

Limits to the Tax Benefit of Debt

• A firm must have taxable earnings to receive the full tax benefits of leverage, without 100% debt financing.
• The optimal level of leverage is where interest equals EBIT, maximizing the tax shield benefit.
• A firm shields all taxable income without excess interest.
• Uncertainty regarding EBIT means there is a risk that interest will exceed EBIT, reducing the optimal level of the interest payment.

Growth and Debt

• Growth affects the optimal leverage ratio.
• To avoid excess interest, a firm with positive earnings should have debt such that interest payments are below expected taxable earnings.
• As EBIT increases, the amount that you can borrow increase
• the higher the growth rate, the higher the value of equity. The optimal proportion of debt in the firm’s capital structure D/(E+D) will be lower

Direct/Indirect costs of Financial Distress

• Direct costs include administrative expenses and disruption of operations.
• Indirect costs include conflicts between stakeholders and a negative perception by financial markets.
• The firm is forced to take actions that it would not otherwise choose.
• Risk of bankruptcy is an important consequence of leverage.
• Using leverage increases the probability of default and the present value (PV) of bankruptcy costs. and creditors will seek higher return on debt.

Financial Distress - Agency Costs

• Agency costs arise due to conflicts of interest between stakeholders (shareholders and debtholders).
• Shareholders pursue profit maximization; debtholders prioritize loan repayment.
• Managers must balance the interests of both stakeholders.
• Shareholders encourage managers to make investments, while debtholders charge costs based on risk.
• Debtholders pay for the financial distress costs; shareholders can walk away.

Static Trade-Off Theory with MM

• Firms balance the tax shield benefits from debt against financial distress and agency costs.
• Firms target an optimal debt ratio and adjust gradually towards it.
• Financial distress and agency costs reduce the firm's value.
• Optimal capital structure is achieved when the present value of benefits of debt exceeds the present value of cost of debt.
• Firms with too much debt should issue stock or sell assets.

Failures of Static Trade-Off Theory

• Some of the most successful companies use no debt.
• Most profitable firms borrow the least.
• Some countries have debt ratios similar to US despite no tax shields.
• Firms do not have well-defined debt ratios.
• This leads to the Pecking Order.

The Pecking Order Theory

• The Pecking Order theory prefers internal funds first, then issue new debt to fund the capital expenditure.
• If the cost of debt is too high, then they will prefer to issue equity.
• Managers will only issue equity if current market value is higher than intrinsic value.
• The role of debt is to avoid issuing equity when internal funds run out.
• External stakeholders assess the firm based on signals sent out.
• Optimistic managers may issue debt, pessimistic issues equity.
• Issuing equity signals that share price is overvalued.

Financial Slack

• Excessive cash can lead to overinvestment and negative NPV projects.
• Debt financing can discipline managers tempted to overinvest.

Managerial Entrenchment

• Managers choose a capital structure to avoid the discipline of debt and maintain their job security.
• Entrenchment is associated with lower debt levels.
• Agency cost of managerial discretion; management will not voluntarily give up cash flow → overinvest. debt prevents this.

What is Convertible Debt

• Allows debtholders to convert debt to equity.
• They will only convert to equity when it is favourable.
• People have stronger motivation to convert debt to equity if stock price increases.

Basic Bond Terminology

• Then the bond price will be issued below the par value if the YTM is higher than the coupon rate.
• Basic features convert security into pre-determined share. A convertible security is a security with an embedded call option to buy the common stock of the issuer.

Callable or Putable Convertible Bonds

• The particular convertible bond can be called back by the issuer if they feel the conversion value is too high - force the debtholders to convert to equity.
• From the holders perspective, they can sell the convertible bond to the issuer if they find the condition is unfavourable = beneficial to bondholders.

The Value of Convertible Bonds

• If stock price is higher than the breakeven point, the conversion value is higher than straight bond value (resulting in investors converting).
• At Debt Maturity Date the Convertible Debt Holder can either surrender convertible debt and receive face value, or convert into common stock.

Convertible Debt - More Formally

• Convertible Debt Value = Debt + Additional Option Value (Call - Conversion Price)
• Use (F/a) to be the Exercise Price for the Call Option (or breakeven point)
• When you want to convert: (Alpha x Value) > Face Value of Convertible Bond at end of maturity date.

Free lunch Story

• If Firm Stock Price Decreases (No Conversion): straight debt is cheaper. Equity CD is more expensive because firm could have issued equity at high price.
• If Firm Stock Price Increases (Conversion Occurs): CD is cheaper, because the firm issues shares at high prices when conversion takes place.

Stulz (1990)

• Debt reduces investment in all states of the world
• Debt has a much wider role than the pecking order, (it is like a double-edged sword):
• Debt can resolve the problem of overinvestment by forcing managers to repay free cash flow as debt when cash flow is higher than expected investment opportunities But when cash flow is lower than expected, debt causes underinvestment because the firm is paying scarce funds as debt rather than using them for investment opportunities; → issue equity but managers can’t convince market

Stulz (1990).

• Underinvestment = forgoing positive NPV projects, overinvestment = accepting negative NPV projects.
• Having debt can reduce overinvestment (discipline managers) and lead to underinvestment.
• This is done by disciplining the manager by forcing them to issue debt.
• Occurs when 'too little' debt was issued ex ante (so debt repayments are low) and good investment opportunities are not ready. Managers may waste free cashflows.

Implications of Stulz (1990)

• Managers overinvest rather than pay out and avoid managers having free cash flow
• The more volatile the cash flows the greater is the problem

Example of Stulz (1990)

• If Planned Capital Expenditure has no project to invest then capital Structure 1 is better to invest (because there can be advantage of tax shield).
• If Planned Capital Expenditure uses all net income, and has too much debt then they will choose to not invest - leading to underinvest or raise more equity because they cannot raise anymore debt.