The Modigliani-Miller Theorem is a foundation of modern corporate finance.

At its core, the theorem is an irrelevance proposition: The Modigliani-Miller

Theorem provides conditions under which a firm’s financial decisions do not
affect its value.
Modigliani and Miller stated:-

… with well-functioning markets (and neutral taxes) and rational

investors, who can ‘undo’ the corporate financial structure by
holding positive or negative amounts of debt, the market value
of the firm – debt plus equity – depends only on the income
stream generated by its assets. It follows, in particular, that the
value of the firm should not be affected by the share of debt in
its financial structure or by what will be done with the returns –
paid out as dividends or reinvested (profitably).

There are 4 distinct propositions by MM.

Under certain conditions, a firm’s debt-equity ratio does not affect its
market value.
A firm’s leverage has no effect on its weighted average cost of capital
(i.e., the cost of equity capital is a linear function of the debt-equity
ratio).
Firm market value is independent of its dividend policy.
Equity-holders are indifferent about the firm’s financial policy.

The MM propositions rest over many assumptions:

Capital Markets have to be well functioning. This means that investors
can trade securities without restriction and can borrow or lend on the
same terms as the firm.
Each firm’s financial policy conveys no new information about the
pattern of its earnings.
Absence of bankruptcy. It means the earnings always exceed the debt
obligations.
Every firm is assigned to a risk class. A risk class is defined as a set of
firms each of which has an identical pattern of earnings payoffs across
the world. Thus the levered and unlevered all belong to same risk
class.
Capital markets are efficient, so that securities are fairly priced given
the information available to investors.
There is no distorting tax and it ignores the cost encountered if a firm
borrows too much and land in financial distress.

Modigliani-Miller – A practical approach 1

 TAX BENEFIT DUE TO DEBT POLICY

We will start with considering a firm working in an ideal environment where

all the above assumptions are taken in consideration, mainly the firm is not
paying any tax. Consider a firm which has invested in some productive asset
which allows it to generate an income (as the earning before interests and
taxes (EBIT)” E” at each time “T”. Roughly speaking, E is equal to the value
of the sales minus production costs. In real world, when positive, E is used to
pay bondholders (coupon), government (tax), and equity holders
(dividends). Let VL (T) be the value of the levered firm at a given time T. We
shall now compute VL (T) under various scenarios.

Unlevered firm
In this simple case, in which C = 0, the value of the unlevered firm at time T,
Value of the unlevered firm VUL (T) is:
VUL (T) = E

Levered firm with no default risk.

We say that the corporate bond is risk-free if the coupon is paid at any time
T to bondholders with probability one. In the risk-free case, the net result
(E - C) is positive with probability one so that the value of the levered firm at
time
T is:
VL(T) = C + (E - C)
=E
= VUL(T)
When there is no corporate income tax, the value of the levered firm (at time
T) is equal to the value of the unlevered one (at time T), i.e., the value of the
firm is invariant with respect to C as long as the coupon implies no default
risk. This is the Modigliani-Miller theorem without default risk.
Further approaching the MMs proposition 2: the behavior of cost of equity
which states the expected returns required by the share holders of a geared
company.

Given that
E/(Vs+Vb) = E/Vo = WACC-----------------------------------------(1)
And Re = (E-C)/Vs---------------------------------------------------(2)
We may write
E = WACC * Vo = WACC (Vs + Vb)---------------------------------(3)
Substituting for E,
Re = ( WACC (Vs + Vb) – C)/ Vs
Re = (WACC * Vs + WACC * Vb – C)/Vs
Re = WACC + (WACC - C/Vb)/(Vb/Vs)
Re = WACC + (WACC – Rd) / (Vb/Vs)

Modigliani-Miller – A practical approach 2

 Since proposition 1 argues that WACC equals return required by the
shareholder in an equivalent un-geared company therefore:

Rg = Re + (Re –Rd) Vb/Vs

Where:
E: earnings
C: coupon rate
WACC: weighted average cost of capital
Rg: returns required by share holders of geared company
Re: returns required by share holders of un-geared company
Rd: return required by providers of debt capital
Vb: market value of company’s outstanding borrowing
Vs: value of share holder stake in the company
Vo: total value of the firm

It simply tells us that rate of return required by shareholders increase

linearly as the debt/equity ratio in increased i.e. cost of equity rises exactly
in line with any increase of gearing to offset precisely any benefits conferred
by the use of any apparently cheap debt.

Rg = Re + (Re –Rd) Vb / Vs

Required return WACC

Rd

Vb / Vs

Now let us consider the corporate world where the tax is levied on the
earnings.

Unlevered firm.
In this simple case, in which C = 0, the value of the unlevered firm at time
T, denoted VUL(T), is:

Modigliani-Miller – A practical approach 3

VUL(T) = E*(1 - Ta)
where Ta be the corporate tax income.

Levered firm, no default risk.

In the risk-free case, the net result (E - C) (1-Ta) is positive with probability
one so that the value of the levered firm at time T is:

VL(T) = C + (E - C)*(1 - Ta)

VL(T) = E*(1 - Ta) + Ta*C
VL(T) = VUL(T) + Ta*C

The value of the levered firm is equal to the value of the unlevered firm
VUL(T), plus the value of the tax-shield Ta*C, which comes from the fact that
interests expenses are tax-deductible.

As seen form above the company value profile now rises continuously with
gearing. With no corporate tax the share holder in a geared company require
a return Rg of:

Rg = Re + (Re – Rd) * (Vb/Vs)

However in taxed world the return required by share holders becomes

Rg = Re + (Re-Rd)*(1 – Ta)* (Vb/Vs)

The premium for financial risk required by shareholders is lower in this

version owing to the tax deductibility of debt interest, making the debt
interest burden less onerous. It follows that if at every level of gearing the
cost of equity is lower and also the cost of debt itself is reduced by interest
deductibility, the WACC is lower at all gearing ratios and declines as gearing
increases.

WACC = Rg * Vs/(Vs + Vb) + Rd* (1 – Ta)* Vs/(Vs + Vb)

which can further be written as?

WACC = Re (1- (Ta * Vb)/(Vs + Vb))

Clearly there is significant advantages from gearing with the implication that
company should gear up until 100 percent of its financing. However it is not
possible or rather sensible given the high risks

Modigliani-Miller – A practical approach 4

 involved.

Rg

Re

Cost of capital
WACC

Rd = C(1-Ta)

Vb/Vs

VL(T) = VUL(T) + Ta* C

Ta * C

VUL(T
)
VUL(T

Vb/Vs

Modigliani-Miller – A practical approach 5

Another advantage of a tax shield to a leveraged firm is it can carry back the
losses to receive amount of taxes paid in the previous 2 years, similarly it
can carry forward the losses to receive tax credit in subsequent years.

Firms with low effective marginal tax rates prefer leasing to increase the
value of its firm, where as firms with high marginal tax rates consider issuing
high interest debt as its interest payment are non taxable.

TAX BENEFIT DUE TO PAYOUT POLICY

Company’s dividend policy is a trade off between paying cash dividend,

issuing equity and repurchasing stock. Lenders may impose some of the
restrictions on the dividend payment in order to have enough cash to pay the
capital. In order to maximize tax benefits, company may offer dividend re-
investment plans which permit the shareholders to reinvest their dividend to
purchase additional shares in the company. This reduces the commission
costs for the investors and provides a saving mechanism. It also acts as
inexpensive means of raising equity capital for the firm’s investment plans.

Capital gains are taxed at lower rates than dividend income. If the dividend
income is at tax-disadvantage the investors will demand high pre tax
dividend return on high pay out stocks. Instead of paying high dividends
companies should choose the cash on repurchase shares to reduce the
amount of the shares issues. In this way the company would be ineffect
convert dividend income into capital gains. This is one reason low-dividend
policy might be preferred.

Taxes on dividends have to be paid immediately but taxes on the capital

gains can be deferred until shares are sold and capital gains are realized.
Stock holders can choose when to sell their shares and thus when to pay the
capital gain tax. The longer they wait the less the present value of the capital
gains tax liability.

The corporations prefer dividends for tax reasons. They pay corporate
income tax only on 30 percent of any dividends received. Thus the effective
tax rate on dividends received by large corporation is 30 % of 35 %, or
10.5%. But they will have to pay 35% tax on the full amount of any realized
capital gain.

Thus with various mathematical and corporate practical application, it has

been successfully discussed that the MM preposition, albeit very academic

Modigliani-Miller – A practical approach 6

but does have a realistic implication of debt and payout policy on the firm’s
value.

References:

Corporate Finance, Brealey, Myers and Allen.

Corporate Finance and Investment, Decision and Strategy, Richard
Pike and Bill Neale.
Fundamentals of Corporate Finance, Brealey, Myers and Marcus.
Modigliani-Miller, “The cost of capital, corporation finance and the
Theory of investment” American Economic Review.

Anupam Moondra
MSc. Shipping Trade and Finance
2008-09

Modigliani-Miller – A practical approach 7