# Modligiani and Miller's Capital Structure Theory

Topics: Finance, Investment, Money Pages: 157 (5265 words) Published: May 4, 2013
Capital
structure
decisions:
To
M&M
and
beyond
Introduction
Modigliani
and
Miller’s
proposition
one
states
that
by
introducing
debt
financing
does
not
change
the
value
of
the
firm
or
the
value
of
the
firm’s
cash-­‐flows
but
only
the
way
that
these
cash-­‐flows
of
the
firm
are
split
between
its
debt
and
equity
holders.

This
is
the
principle
of
conservation
of
value:

“no
change
in
the
investment
value
of
the
enterprise
as
a
whole
would
result
from
a
change
in
its
capitalization.”[1]

Therefore,
the
value
of
the
firm
is
equal
to
the
value
of
its
debt
plus
its
equity.
V
=
D
+
E
Modigliani
and
Miller’s
proposition
two
states
that
by
introducing
debt
financing
does
not
change
the
cost
of
capital
to
the
firm
but
merely
changes
the
way
risk
is
divided
between
debt-­‐holders
and
equity-­‐holders.

This
is
the
principle
of
conservation
of
risk.

Because
debt
has
a
prior
claim
on
the
firm’s
cash-­‐flows,
the
introduction
of
debt
increases
the
risk
to
shareholders
since
shareholders’
returns
come
after
those
of
debt-­‐holders.

This
is
effectively
a
transfer
of
risk
from
debt
to
equity
–
because
debt
claims
come
before
those
of
equity
(for
the
same
firm)
debt
will
be
less
risky
(than
equity)
but
the
presence
of
this
debt
makes
equity
returns
more
risky
(than
for
an
all
equity
financed
firm).

The
overall
risk
of
the
firm
remains
unchanged,
just
the
way
that
risk
is
divided
between
debt
and
equity
changes
as
the
capital
structure
changes.

ko
=
(D/V)kd
+
(E/V)ke

and

ke
=
ko
+
(ko
–
kd)(D/E)

Why
does
debt
make
equity
more
risky?
The
way
I
think
of
it
is
as
a
queuing
problem.

In
the
case
of
an
all
equity
firm,
the
equity-­‐holders
get
all
the
returns
-­‐
there
is
no
one
in
front
of
them
in
the
queue
for
returns
from
the
company.
In
the
case
of
a
firm
with
debt,
the
debt
holders
have
a
priority