SUMMARY REPORT
M&M Theorem
The M&M Theorem, or the Modigliani-Miller Theorem, is one of the most important
theorems in corporate finance. The theorem was developed by economists Franco Modigliani
and Merton Miller in 1958. The main idea of the M&M theory is that the capital structure of a
company does not affect its overall value.
M&M Theorem in the Real World
Conversely, the second version of the M&M Theorem was developed to better suit real-
world conditions. The assumptions of the newer version imply that companies pay taxes; there
are transaction, bankruptcy, and agency costs; and information is not symmetrical.
PROPOSITION I (M & M II)
The first proposition states that tax shields that result from the tax-deductible interest
payments make the value of a levered company higher than the value of an unlevered
company. The main rationale behind the theorem is that tax-deductible interest payments
positively affect a company’s cash flows. Since a company’s value is determined as the present
value of the future cash flows, the value of a levered company increases.
PROPOSITION II (M & M II)
The second proposition for the real-world condition states that the cost of equity has a
directly proportional relationship with the leverage level. Nonetheless, the presence of tax
shields affects the relationship by making the cost of equity less sensitive to the leverage level.
Although the extra debt still increases the chance of a company’s default, investors are less
prone to negatively reacting to the company taking additional leverage, as it creates the tax
shields that boost its value.
M & M 1963 WITH TAXES
Value is maximized at 100% debt.
Proposition 1: The value of a leveraged firm increases as leverage increases, due to the
tax shield.
Proposition 2: The increase in the cost of equity is reduced by the tax shield, leading to
the WACC being minimized at 100% debt
BANKRUPTCY COST
Higher costs of capital and an elevated degree of risk may, in turn, increase the risk of
bankruptcy. As the company adds more debt to its capital structure, the company's WACC
increases beyond the optimal level, further increasing bankruptcy costs. Put simply, bankruptcy
costs arise when there is a greater likelihood a company will default on its financial obligations
because it has decided to increase its debt financing rather than use equity.
Direct Costs
These are expenses directly associated with the bankruptcy process itself. Examples include:
Legal Fees: Costs incurred for hiring attorneys to navigate the bankruptcy proceedings.
Administrative Costs: Fees for court filings, financial advisors, and other administrative
tasks.
Asset Liquidation Costs: Expenses related to selling off company assets to pay
creditors, often resulting in lower-than-expected returns.
Indirect Costs
These costs arise from the effects of bankruptcy on a firm's operations and relationships.
Examples include:
Loss of Customers: Clients may choose to stop doing business with a company
perceived as unstable, leading to a decline in revenue.
Employee Morale and Productivity: Employees may become demotivated or leave the
company, increasing turnover costs and decreasing productivity.
Supplier Relationships: Suppliers may demand stricter credit terms or refuse to do
business with the company, impacting its ability to operate effectively.
Capital Optimal Structure
The optimal capital structure of a firm is the best mix of debt and equity financing that
maximizes a company’s market value while minimizing its cost of capital
What determines the Optimal Capital Structure?
Corporate Lifecycle → The capital structure of a company tends to shift toward a greater
proportion of debt as opposed to equity in the latter stages of its lifecycle. The stage at which a
company is currently in its lifecycle often dictates its optionality to raise debt at reasonable rates.
Early-stage companies, on the other hand, seldom carry traditional debt on their balance sheet
for the aforementioned reasons.
Tax-Deductibility of Interest → Given the tax-deductibility of interest expense – where interest
reduces the pre-tax income (EBT) line item on the income statement – an increase in leverage
causes the firm valuation to initially rise. However, the tax savings are eventually offset by the
risk of default, where existing and potential capital providers are placed at risk, i.e. the higher
risk coincides with a higher required rate of returns to compensate for the incremental risk.
Business Risk → Business risk is the risk inherent to the operating performance of a firm,
assuming no debt. For instance, changes in consumer preferences, changes in unit costs, and
increased competition. Generally the greater a firm’s business risk, the less financial leverage
there is in the optimal capital structure
Agency Costs → Agency costs refer to the risk of discrepancies forming between management
and stakeholders, which is often termed the principal-agent problem, where differences in
viewpoints can cause the company to incur steep losses (and a reduction in valuation
Lender Risk-Appetite → Most risk-averse lenders, namely banks, prioritize capital
preservation, even if it means receiving a lower yield on a lending arrangement.
REFERENCES
https://youtube.com/watch?v=DoLc5CCqd3g&si=_KkmwKf_wWv-deRV
RRL
https://www.investopedia.com/terms/m/modigliani-millertheorem.asp
https://www.investopedia.com/terms/o/optimal-capital-structure.asp#:~:text=Error%20Code%3A
%20100013)-,What%20Is%20Optimal%20Capital%20Structure%3F,due%20to%20its%20tax
%20deductibility.
https://www.investopedia.com/ask/answers/061515/how-do-bankruptcy-costs-affect-companys-
capital-structure.asp
https://study.com/academy/lesson/mm-proposition-i-ii-with-corporate-taxes.html
https://corporatefinanceinstitute.com/resources/valuation/mm-theorem/
https://prepnuggets.com/cfa-level-1-study-notes/corporate-issuers-study-notes/capital-
structure/theories-of-capital-structure-i-mm-propositions/#:~:text=MM%201963%20(With
%20Taxes)&text=Proposition%201%3A%20The%20value%20of%20a%20leveraged%20firm
%20increases%20as,being%20minimized%20at%20100%25%20debt.
