upon further assumptions, that (i) EBIT is constant and (ii) earnings are paid out
of dividends7.7 The profit motive would bring the equilibrium in the values of the two firms.
Therefore MM maintains that WACC and the firm’s value must be independent of
capital structure. In the cases where transactions costs are significant or in a
situation of non-identical risk, this arbitrage process of MM theory cannot be
invoked.
7.8 In 1958 MM theory assumed Zero tax and subsequently in 1963, they modified
the theory by incorporating corporate taxes. Since the interest on debt finance is
exempted from corporate tax, the leverage may have positive effect to increase a
firm’s value. Therefore, the value of levered firm will increase because of
leverage when compared to the value of un-unlevered firm, because the unlevered
firm will not have benefit of the value of tax savings. As the debt rises, gain from
leverage raises.
7.9 The taxes reduce the effect of cost of debt equal to interest rate. Therefore the
firm’s value increases as it leverages increases.
- The Hamada Model
8.1 The stand-alone risk is a measure of financial risk. The stand-alone risk can be
reduced, by diversification in individual portfolios.
8.2 Robert Hamada merged CAPM and MM after-tax –model, to obtain the cost
equity to a leveraged firm.
8.3 The rate of return on a stock at a particular required level can be classified in to:
- The risk free rate i.e., compensation to shareholders for the time value of
money - A premium for business risk
- A premium for financial risk
8.4 The premium for financial risk would be zero in the absence of financial leverage.
In such situations the shareholders gets compensation only for business risk.
8.5 The addition of debt to the existing capital structure results in new value, resulting
in a financial risk premium on the Stock. This will also add to the business risk
premium.
- Miller Model
9.1 Prof Merton Miller designed a new model incorporating both corporate tax and
personal tax to show how leverage affects firm’s values.