Capital Structure Theory 4875 .All investors have the same information as management about the firm’s future
investment opportunities.
6 .EBIT is not affected by the use of debt.
If these assumptions hold true, MM proved that a firm’s value is unaffected by its
capital structure, hence the following situation must exist:. (13-4)
Here VLis the value of a levered firm, which is equal to VU, the value of an identical
but unlevered firm. SLis the value of the levered firm’s stock, and D is the value of its
debt.
Recall that the WACC is a combination of the cost of debt and the relatively
higher cost of equity, rs. As leverage increases, more weight is given to low-cost debt,
but equity gets riskier, driving up rs. Under MM’s assumptions, rsincreases by exactly
enough to keep the WACC constant. Put another way, if MM’s assumptions are
correct, it does not matter how a firm finances its operations, so capital structure
decisions would be irrelevant.
Despite the fact that some of these assumptions are obviously unrealistic, MM’s ir-
relevance result is extremely important. By indicating the conditions under which cap-
ital structure is irrelevant, MM also provided us with clues about what is required for
capital structure to be relevant and hence to affect a firm’s value. MM’s work marked
the beginning of modern capital structure research, and subsequent research has
focused on relaxing the MM assumptions in order to develop a more realistic theory of
capital structure.
Another extremely important aspect of MM’s work was their thought process. To
make a long story short, they imagined two portfolios. The first contained all the eq-
uity of the unlevered firm, and it generated cash flows in the form of dividends. The
second portfolio contained all the levered firm’s stock and debt, so its cash flows were
VLVUSLDSECTIONII. 100,000 OFDEBT
Debt $100,000
Book equity $100,000
Interest rate 10%
Demand for Pre-Tax Taxes Net
Product Probability EBIT Interest Income (40%) Income ROE
(1) (2) (3) (4) (5) (6) (7) (8)
Terrible 0.05 ($ 60,000) $10,000 ($ 70,000) ($28,000) ($42,000) 42.0 %
Poor 0.20 (20,000) 10,000 (30,000) (12,000) (18,000) 18.0
Normal 0.50 40,000 10,000 30,000 12,000 18,000 18.0
Good 0.20 100,000 10,000 90,000 36,000 54,000 54.0
Wonderful 0.05 $140,000 $10,000 $130,000 $52,000 $78,000 78.0
Expected value: $ 40,000 $10,000 $ 30,000 $12,000 $18,000 18.0 %
Standard deviation: 29.6 %
Coefficient of variation: 1.65TABLE 13-1 Continued