Unformatted text preview: In a perfect capital market firm value is independent of the capital structure MM-theory demonstrates that if capitals markets are doing their job firms cannot increase value by
changing their capital structure. In addition, one implication of MM-theory is that expected return on
assets is independent of the debt policy. Download free ebooks at bookboon.com
59 Corporate Finance Corporate ﬁnancing and valuation The expected return on assets is a weighted average of the required rate of return on debt and equity, (42) rA D
DE Solving for expected return on equity, rE, yields: (43) rE rA rA rD D
E This is known as MM's proposition II.
Miller and Modigliani's Proposition II
In a perfect capital market the expected rate of return on equity is increasing in the
debt-equity ratio. rE rA rA rD D
E At first glance MM's proposition II seems to be inconsistent with MM’s proposition I, which states that
financial leverage has no effect on shareholder value. However, MM's proposition II is fully consistent
with their proposition I as any increase in expected return is exactly offset by an increase in financial risk
borne by shareholders.
The financial risk is increasing in the debt-equity ratio, as the percentage spreads in returns to shareholders a...
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