Part 2:
Introduction
The Capital Structure Propositions proposed by Nobel Laureates, Franco Modigliani and Merton Miller has a significant relevance even in the modern day financial theory. The propositions proposed by them are popularly known as MM Propositions which they proved under restrictive set of assumptions to counter the traditional approach of capital theory which states that there is always an optimum mix of capital structure for a firm that assists in attaining maximum value for it. The difference in the traditional approach and MM Propositions will be discussed in detail in the succeeding sections, while now we will explain the propositions proposed by the eminent finance professors.
MM’s Propositions:
Assumptions
MM study of capital structure of a company is based on very restrictive assumptions which are:
- Perfectly Competitive Capital Markets: There are no taxes, bankruptcy costs or any other agency costs
- Investors in the market share homogeneous expectations with respect to cash flows generated by the firm
- Investors can borrow or lend at the risk-free rate
MM Proposition I (Without Taxes): Capital Structure Irrelevance Proposition
Under the assumptions of perfect market, value of an unlevered firm will be equal to the value of a levered firm. In other words, it does not matter if one firm is having high debt while the other is having low debt capital; the value of either the firm will be equal, i.e.
VL= Vu
VL= Value of a levered firm
VU= Value of an unlevered firm
For Instance, if firm A is unlevered, in that case, equity holders of the company are solely entitled to the operating earnings of the company and value of the firm will the discounted present value of these earnings. Now, on the other hand, if Firm B is levered partially with debt, its earnings will be divided proportionality between the debtholders and equityholders.
However, under the assumption of perfect market, the value of the firm fully financed with equity is equal to sum of firm’s debt and equity. Hence, in either case, the value of both the firms will be equal, irrelevant of the fact that they are levered or unlevered.
Theoretical Proof: Arbitrage
In order to prove this proposition, let us assume that an investor is considering option to purchase shares of unlevered firm A or levered firm B. Now, since he can substitute his own leverage with that of company’s leverage, he will go for stock of unlevered firm A and borrow same amount of debt as did by firm A. Since this whole process is costless, the returns earned by investors will be same under either of conditions proving that a company’s capital structure is irrelevant in the presence of perfect capital markets. This whole process can be termed as Arbitrage that will prove the Proposition I of the MM theory.
MM Proposition I (With Taxes): Value of a firm is maximized at 100% debt
Removing assumptions that there are no taxes, the results of their previous proposition relating to capital structure irrelevance is changed. In other words, assuming that tax exists, the levered firm will be able to gain benefit of tax shield offered by debt financing because interest paid on debt funds can be claimed as pre-tax expense. Here the term tax shields refer to marginal tax rate multiplied by the amount of debt in the capital structure. Hence, since a levered firm can enjoy tax shield its value will be higher than an unlevered firm by the tax benefit gained by levered firm:
VL= VU+ (tax rate* d)
VL= Value of a levered firm
VU= Value of an unlevered firm
D= Debt Capital
MM Proposition II (No Taxes): Proportion of cost of equity and debt financing
Assuming capital markets are perfect, MM Proposition II states that the cost of equity of a firm is directly proportional to the level of debt in the capital structure. For Instance, as the company acquires more debt financing, the risk of equityholders increases and hence, the cost of equity increases. In this way, the advantage of including debt as a cheaper source of financing if offset with increased cost of equity. However, since the capital structure of a firm is irrelevant, as leverage increases, the cost of equity increases but Weighted Average Cost of Capital (WACC) remains constant.
Cost of Equity
WACC
Cost of Debt
Theoretical Proof: Use of Proposition I
In order to prove their Proposition II, MM have used proportion I where they stated that the value of the firm is irrelevant of its capital structure. Important to note, the professors actually revised their Proposition I in the year 1963 and proposed Proposition II.
MM Proposition II (With Taxes): WACC is minimized at 100% debt
Removing the assumptions that there are no taxes in the market, if the firm includes more debt in its capital structure, the tax savings associated with debt financing will decrease the WACC as leverage increases. Hence, the value of firm will be maximized at 100% debt.
MM Proposition III:
This proposition is least discussed and propose that wealth of a shareholder of a company is maximized by substituting the cost of equity of an unlevered firm for the WACC (cut-off rate) of a levered firm
Theoretical Proof: Use of Proposition II
Proposition III has been proved by logically using Proposition II where the fundamental market value of an unlevered firm is equal to value of equity.
Difference between MM Theory and Traditional Capital Theory under no-tax world:
The conclusion of MM theory was completely opposite to that of Traditional Capital Theory. Assuming a world where there is no tax, the latter theory proposed that with the increase in borrowings, the WACC will start falling and after some point, WACC will stop falling and will turn constant. Hence, a firm with leverage will only be able to reap benefits of debt financing up to an optimum point because post that optimum point, WACC will again start increasing and value of firm will start decreasing.
On the contrary, MM theory had an opposite view where they proposed that under the assumption of no taxes, as the firm increases debt financing in its capital structure, although its cost of equity will increase because of higher risk embedded with debt financing, however, since lower cost of debt is set-off by higher cost of equity, WACC will remain throughout and there is no term as ‘’optimal debt-equity ratio’’.
Implications of MM’s hypothesis for Financial Management
Since MM’s hypothesis are widely accepted in the modern corporate finance, we can believe them to be true and have a significant impact in the context of investment appraisal. The major implication of MM hypothesis is that a traditional view where the financial decisions confronted with that of management and included debt are to be completely eliminated now. In other words, leverage is irrelevant for the purpose of project appraisal and any point where managers are considering shareholder wealth maximization, leverage should not be considered as at the inclusion of debt, WACC and the value of firm remains same through contrary to the traditional view.
Part 1
Defining Efficiency
In reference to the financial markets, the term efficiency refers to the capital market where the current stock prices includes all the relevant information related to the security. In a simplified way, markets can said to be efficient when the current stock prices accurately represents the risk and are unbiased estimates of their value so that the expected return to the investor corresponds the equivalent risk premium to compensate him.
Forms of Efficient Market Hypothesis (EMH)
While there is one section of analyst that say ‘’Investors can’t beat the market’’, the other section of them raises concerns that market is never efficient and the presence of anomalies always prevent it from being efficient. To solve the puzzle, it was the Nobel laureate, Professor Eugene Fama who originally developed the concept of market efficiency and indicated three forms of market efficiency which are as follows:
i) Weak Form market efficiency: The weak form of EMH states that the current price of the stock reflects all the information related to current available data about the stock. Hence, neither analyst nor any investor can earn abnormal returns using past prices and volume information as the price changes will be independent from one period to the other. Thus, any form of technical analysis will turn meaningless here.
ii) Semi-strong form market efficiency: The semi-strong form of EMH states that the current stock prices not only reflects information relating to past prices and stock volume, but also adjust rapidly without any biases to the arrival of new public information. Hence, with stock prices including both market as well as non-market information, analysts and investors will not be able to abnormal returns using fundamental analysis.
iii)Strong-form market efficiency: This form of EMH states that the current stock prices not only includes market and non-market information, but also the private information. Hence, there is no group of investors has any monopolistic information that can help him earn abnormal returns.
Implications of EMH for stock valuation and takeover in the corporate world
Researchers on timely basis have used various tests such as Filter Tests and Event Studies to check if the markets are Weak form efficient, Semi-Strong efficient or Strong-form efficient. While there is a common consensus that given the prohibition on insider trading in all the financial markets, no financial market is strong-form efficient. However, the research results have shown that investors on a general basis takes their investment decision on the assumption that markets are semi-strong efficient. In such situation, following will be the implication of EMH:
i)Since markets are semi-strong efficient, investors can only earn through speculative investment if they have access to private information. In reality, ‘’we indeed cannot beat the markets’’
ii) The prices of both existing as well as new issued shares should be based on their fundamental value and will not be based on market sentiments.
iii) As we cannot use technical or fundamental analysis to beat the market, instead of stock picking, it will be rational to invest in Passive-index funds that provide average market returns. In other words, there is no best time to purchase the stocks as past price patterns will help us with nothing.
iv)In total, investment is a zero-sum game where the investor will be able to earn risk appropriate to the risk levels.
v)Even the takeover transactions are zero-sum games unless the management is able to identify any synergies or high economies of scale associated with the takeover.
vi)Asset prices changes will take a random walk and all the projects with positive NPV will be directed towards shareholder wealth maximization as even NPV is a zero-sum game.
Works Cited
Hill, R. A. (2010). Debt Valuation and Cost of Capital. In R. A. Hill, Strategic Financial Management (p. 78).
Kaplan Inc. (2012). Capital Strcuture. In K. Inc, Schweser Notes for CFA Exam- Corporate Finance (p. 276). USA: Kaplan Inc.
Kaplan Inc. (2012). Capital Structure. In K. Inc, Schweser Notes for CFA Exam- Corporate Finance (pp. 278-279). USA: Kaplan Inc.
Market Efficiency. (n.d.). Retrieved November 13, 2014, from Investopedia: http://www.investopedia.com/terms/m/marketefficiency.asp
Riley, K. B. (2011). Market Efficiency. In C. Institute, Equity Investments (pp. 67-73). Boston: Custom.
