Capital Structure Theories: Modigliani-Miller Propositions

This document discusses the Modigliani-Miller capital structure theories and their impact on the market value of a firm. It explains the different propositions proposed by M&M and their implications on the capital structure. The document also covers topics such as WACC, cost of debt, risk-free rate, debt-to-equity ratio, and equity beta.

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Assessment 1 - Assignment
Unit: FIN201 – Corporate Finance

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Question 1:
Part 1:
Formula of simple interest: Principal*Time period * Interest rate (Brigham, F., and Michael C.
2013)
Funds deposited in each year
Year Amount Time
Year 1
$
100.00
At the starting of the
year
Year 2
$
200.00
At the starting of the
year
Year 3
$
300.00
At the starting of the
year
Year 4
$
-
Year 5
$
-
Interest Rate for each
period 7.00% simple interest rate
Note: Note: It has been assumed that all funds have been deposited each year and at the starting
of the year. It is also assumed that interest gathered in each year is not available for reinvestment
in subsequent years.
Value of funds deposited after three years using Simple interest
Principa
l
Period of investment in
years
Interest
Earned
Initial
Amount
Future
Value
$
100.00 3
$
21.00
$
100.00
$
121.00
$
200.00 2
$
28.00
$
200.00
$
228.00
$
300.00 1
$
21.00
$
300.00
$
321.00
$
70.00
$
600.00
$
670.00
Value of funds deposited after three years using Simple interest
Principa
l
Period of investment in
years
Interest
Earned Initial Amount
Future
Value
$
100.00 5
$
35.00
$
100.00
$
135.00

3
$
200.00 4
$
56.00
$
200.00
$
256.00
$
300.00 3
$
63.00
$
300.00
$
363.00
$
154.00
$
600.00
$
754.00
Part 2:
Value of funds deposited after three years using Simple interest
Principal Period of investment in years
$ 100.00 5
$ 200.00 4
$ 300.00 3
Where:
 C refers to the periodic payment in form of coupon payments
 F refers to par value or face value of bond
 r: Yield to maturity (YTM)
 n = periods till the maturity of bond (Brigham, F., and Michael C. 2013)
Part 2 Bond Face Value $ 100.00
Coupon Rate 14%
Coupon paid Semi-Annually
Yield to Maturity 16%
Each Coupon Payment $ 7.00
Number of coupon payments 20
Yield to Maturity for each coupon period 8%
Bond Face Value $ 100.00
Part 3:

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PV of par value $ 21.45
Price of Bond $ 90.18
Part 3 Data Given
PV of par value $ 21.45
Price of Bond $ 90.18
Part 3 Data Given
Security Amount Invested Expected Return
Calculation of weigghts of each security
Security Amount Invested Weights
Share A $1,000 10.00%
Share B $2,000 20.00%
Share C $3,000 30.00%
Share D $4,000 40.00%
Total $10,000 100.00%
(Damodaran, 2011)
Share A 10.00% 8%
Share B 20.00% 12%
Share C 30.00% 15%
Share D 40.00% 18%
Expected Return of Portfolio
Calculation of beta of portfolio
Security Weights Beta
Systematic risk refers to the beta value and portfolio has higher systematic risk than the
average asset as average beta of all beta values for 4 shares is 1.06 which is lower than weighted
beta of portfolio (Damodaran, 2011)
.

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Question 2:
Security Beta
Standard
Deviation
Part 1: Total risk refers to the combined value of risk generated through the impact of
systematic risks and unsystematic risks. Systematic risk can be measured through use of beat
values but there are no set criteria to measure the unsystematic risk. In order to best measure the
value of total risk, standard deviation can be used as it measures how much security deviates
relative to its mean. So standard is best measurement of total risk. Security that deviates more
from its means tend to provide more risk as compare to security that deviates less. So, security A
has greater total risk due to high standard deviation (Davies and Crawford, 2011).
Part 2: Systematic risk refers to the market risk and this risk arises due to uncertainty poses in
the entire market. This risk can be measured through use of beta coefficient and security which
has higher beta value tends to have more systematic risk as compare to security that tend to have
lower beta value. In the given case Security B tends to have higher systematic risk as it has
higher beta coefficient value.
Part 3: Diversification cannot eliminate the systematic risk as systematic risk arises due to
change in market condition. Market impacts all the listed securities equally and in relation to the
beta coefficient. So diversification cannot be used to eliminate the systematic risk.
Diversification can reduce or minimize the overall beta value of the portfolio but cannot
eliminate it.
Part 4: Security market line (SML) refers to the line that represent capital asset pricing model.
In case if investment has positive net present value it will have greater return as it is expected
which means it will plot above the security market line as expected return is shown on Y axis
and beta value on X axis. If return increases value of Y will increase and line which drawn above
the given SML line (Davies and Crawford, 2011).

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Answer
A:
Modigliani-Miller has proposed capital structure theories during the period of 1950s for
determining the market value of a firm. The theory is developed on the basis of hypothesis that in
a perfect structure there is no relatively impact on the type of capital structure of a firm on its
operations. They have proposed that the market value of a firm is impacted by its earning power
and the risk of the underlying assets. The value is relatively independent by the way the firm
selects the method of financing its investments or distributes dividends. The key assumptions
that are adopted by them during the development of M&M theory is that there are no taxes, no
cost of transaction, market information is symmetric and there is no impact of debt on the
earning potential of a firm (Smirnov, 2018). The different M&M positions that have been
proposed can be discussed as follows:
M&M Proposition I
It has been stated by M&M proposition I that there is relatively no impact of the leverage
used by a firm on its market valuation that it adopts for financing its operational activities. The
market value of a firm can be determined through calculating the present value of the cash
inflows that is to be realized from its asset base in the future context. As such, as per this
proposition the value of an unlevered firm is equal to the value of equity whereas in case of
levered firm it is equal to the proposition of debt and equity. Therefore, as per the theory the
value of levered firm is equal to the value of unlevered firm as it is dependent on the present
value of the future cash inflows. As such, there are no tax shields as per this proposition and thus
the market value is not influenced by the changes occurring within the capital structure
(Modigliani & Miller’s Propositions in Finance, 2018). It can be depicted by the use of following
graph:

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(Source: http://financialmanagementpro.com/modigliani-miller-theories-of-capital-structure/)
M&M Proposition II
This proposition has stated that the expected return on equity increases in proportion to
the rise in the debt to equity ratio. It is based on the assumption that the average cost of capita of
a firm is relatively constant and therefore the firms are not able to gain any benefit from the use
of debt in their capital structure. This is because the gains to be realized from the lower cost of
debt are offset by the increased expected return on equity (Baker and Martin, 2011). The
proposition can be depicted by the use of following graph:

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(Source: http://www.graduatetutor.com/corporate-finance-tutoring/modigliani-miller-mm-
propositions/)
M&M Proposition III
This proposition has stated that in the present of tax shields the value of a firm is
significant impacted by the changes in the capital structure and the expected return on equity
increases with the rise in the debt to equity ratio (Miglo, 2016). It can be depicted by the use of
following graph:
(Source: http://www.graduatetutor.com/corporate-finance-tutoring/modigliani-miller-mm-
propositions/)
B:

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WACC
Cost of debt
Risk free rate
Debt to equity ratio
Equity beta
D/V
E/V
Kd
WACC
Ke
Ke
(Smirnov, 2018)

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References
Baker, H. and Martin, G. 2011. Capital Structure and Corporate Financing Decisions: Theory,
Evidence, and Practice. John Wiley & Sons.
Brigham, F., and Michael C. 2013. Financial management: Theory & practice. Canada: Cengage
Learning.
Damodaran, A, 2011. Applied corporate finance. USA: John Wiley & sons.
Davies, T. and Crawford, I., 2011. Business accounting and finance. USA: Pearson.
Miglo, A. 2016. Capital Structure in the Modern World. Canada: Springer.
Modigliani & Miller’s Propositions in Finance. 2018. [Online]. Available at:
http://www.graduatetutor.com/corporate-finance-tutoring/modigliani-miller-mm-propositions/
[Accessed on: 29 March 2019].
Smirnov, Y. 2018. Modigliani-Miller Theories of Capital Structure. [Online]. Available at:
http://financialmanagementpro.com/modigliani-miller-theories-of-capital-structure/ [Accessed
on: 29 March 2019].