MMPropositionsIAndII

MMPropositionsIAndII - MM Propositions I and II (No...

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MM Propositions I and II (No Frictions) 1 The Modigliani and Miller propositions say the following: Suppose that there are no taxes or costs of financial distress . Then I The value of the firm is independent of the choice of capital structure (what % is debt, what % is equity). II The cost of equity capital is increasing in the percentage of debt in the capital structure. In fact, r E = r 0 + D E ( r 0 - r D ) where r 0 is the cost of capital if the firm were financed entirely with equity, r D is the cost of debt capital, D is the market value of debt, and E is the market value of equity. The first statement says that the choice of capital structure is irrelevant for max- imizing the value of the firm. The value of the firm is determined by the left hand side of the balance sheet (the assets) rather than the right hand side (the capital structure). The second statement says that the greater the percentage of debt in the capital structure, the greater the rate of return required by equity holders for a given required rate of return r D . Both of these statements will need to be modified when we introduce taxes and bankruptcy costs (costs of financial distress). Proof of MM Proposition I: Consider a company with no debt (we call it Company U). Company U has a required rate of return of 12.5% and 100 shares outstanding. Suppose that one of three things could happen next year. With probability 1/2,
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MMPropositionsIAndII - MM Propositions I and II (No...

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