The Modigliani and Miller view of gearingbecause of higher risk. The net effect of these factors on the value of each share will be
zero, that is, the effects will be equal and opposite (according to MM).
According to MM, the relationship between the return expected by the capital mar-
ket and the level of gearing is:kEG=kEE+(kEE−kB)where kEGand kEEare respectively the expected returns from shares in the geared and
all-equity businesses; BGand SGare respectively the total market value of borrowings
and shares of the geared business; and kBis the interest rate on borrowing.
Thus the introduction of 50 per cent gearing into the capital structure of La Mer
would push the capital market’s expected return on the business’s equities up to 18
per cent (kEG= 14 +(14 −10)(£1 million/£1 million) =18%). The expected earnings per
share of 18p (see page 295) would still only be worth £1.
MM’s disagreement with the traditionalists was that MM saw the capital market’s
expectations of the return on equities as increasing as soon as gearing is introduced,
and increasing in proportion to the amount of gearing. The traditionalists felt that this
would not occur at lower levels of gearing.
The formal proof of the MM proposition is developed in Appendix I of this chapter.The MM assumptions
The MM analysis is based on several assumptions, which we shall now consider.‘Shares can be bought and sold without dealing costs’
This is obviously unrealistic: brokers’ commissions and other costs are involved with
trading in shares. It is doubtful, however, whether the weakness of this assumption
seriously undermines the proposition. It might mean that investors would be unable
to make a profit by exploiting minor instances of mispricing of shares of geared busi-
nesses, relative to those of ungeared ones. The larger instances of mispricing could be
exploited despite the existence of dealing charges.‘Capital markets are efficient’
The evidence seems to show that they are efficient, for practical purposes, in the weak-
and semi-strong forms (see Chapter 9). This implies that investors would see through
the financial packaging and realise that income of a particular risk class is equally
valuable irrespective of how it is wrapped. It seems that this assumption is reasonable.‘Interest rates are equal between borrowing and lending, businesses
and individuals’
Clearly, this is invalid. In particular, there is usually a difference between the rates at
which individuals and businesses can borrow. Large businesses, in particular, can
often offer good security, can borrow large amounts, and can exploit borrowing
opportunities not open to most individuals (for example, borrowing overseas). The
importance of this assumption lies in the question of homemade gearing, where the
investor borrows on his or her own account and buys shares in the ungeared business.
There is no reason, however, why the investor who exploits any mispricing of
shares need be an individual; it could be a large institutional investor. After all, most