13: Capital Structureconclusions from it. In reality, information is asymmetric: we do not all share the same knowledge, and
even if we did, our interpretations of it often varies from person to person. The asymmetric information
problem is sometimes also called the hidden information problem, because a given piece of information
may be hidden from some of the market participants.
Although these assumptions – forbidding the principal–agent problem and information asymmetry,
eliminating all market frictions such as taxes, and asserting that investors can borrow and lend at the
corporate rate – clearly do not correspond to conditions in real markets, M&M’s conclusions remain
significant. Collectively, these assumptions provide us with a concept of an ‘efficient’ market, one in
which the actions of agents and principals will work to ensure that the value of a company is maximised
as far as possible within the competitive constraints of the market.
The value of the M&M result is that it provides a benchmark against which we can compare real
markets. If a change of capital structure does in fact change the value of the company, then at least one
of the key assumptions must have been violated; and this insight gives us a way to identify the reason for
capital structure having an effect on company value – we just need to check which of the assumptions
has been broken in the real market.
M&M made an important distinction between a company’s business risk and its financial risk. Business
risk refers to the variability of a company’s cash flows, whereas financial risk refers to how a company’s
financing choices affect how this risk is distributed to its shareholders and bondholders. HTMC’s
business risk is determined by how its earnings, before interest and taxes, fluctuate with the state of
the economy. Notice that, in the example of HTMC, the volatility of EBIT is the same whether HTMC
recapitalises or finances with 100% equity. In either case, its EBIT will be $500,000; $1,000,000; or
$1,500,000; depending on the state of the economy.
If HTMC retains its all-equity structure, then the financial risk that shareholders bear equals
HTMC’s underlying business risk. With no debt, the variations in EBIT translate directly into variations
in EPS. However, under the 50–50 recapitalisation, HTMC’s leverage magnifies the financial risk borne
by shareholders. With debt, HTMC issues a claim to bondholders that insulates them entirely from
the company’s business risk. Whether the economy booms, grows normally or falls into a recession,
bondholders receive the $300,000 interest payment they are promised. In this example, because
bondholders bear no risk, even though HTMC’s business risk hasn’t changed, the shareholders remaining
after the recapitalisation have to shoulder even more risk than they did before.13 -2a M&M PROPOSITION I: CAPITAL STRUCTURE IRRELEVANCE
Modigliani and Miller’s Proposition I asserts the following: The market value of any company equals the
value of its assets and is independent of the company’s capital structure. The value of the assets, in turn,
equals the present value of the cash flows generated by the assets. Because the proposition leads to the
conclusion that the company’s capital structure does not matter, it is popularly known as the irrelevance
proposition.
We can develop a simple, mathematical expression of this idea as follows. Assume that investors
expect a company to generate a constant EBIT (assumed equal to net operating income) stream each
year for the foreseeable future. The company may have outstanding debt with market value equal to D
and/or equity with a market value equal to E. By definition, the total value of the company’s outstanding
securities is V, where V = D + E. This expression states a company’s value equals the combined value ofbusiness risk
The variability of a company’s
cash flows, as measured by
the variability of EBIT
financial risk
How a company’s financing
choices affect how its
business risk is distributed
to its shareholders and
bondholdersLO 13.2
Proposition I
The famous ‘irrelevance
proposition’, which asserts
that the market value of any
company equals the value of
its assets and is independent
of the company’s capital
structure. Company value is
calculated by discounting the
company’s expected EBIT at
the rate ra, appropriate for the
company’s business risk