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Capital Structure (MM Propositions (No Taxes) (Assumptions (No taxes…
Capital Structure
MM Propositions (No Taxes)
Proposition 1 - the value of the firm is unaffected by the capital structure
Investors can recreate the effect of corporate leverage personally by borrowing, or remove the effects by lending
Proposition 2 - expected return increases as debt to equity ratio increases (due to more risk)
WACC is constant at all D/E ratios because the value of the firm is constant at all D/E ratios
Assumptions
No taxes
Unrealistc
No transaction costs
Unrealistic
Corporate borrowing rate = Investor borrowing rate
Realistic as investors can use brokers (brokers require investors contribute own funds and top-up any loss due to share price decrease thus reducing brokerage risk
Most companies in a given industry tend to have similar D/E ratios, suggesting that a best ratio does in fact exist. This is because some of the MM assumptions are not realistic
MM Propositions (With Taxes)
Proposition 1 - The value of the levered firm is equal to the value of the unlevered firm plus the present value of the tax shield
Tax Shield - Interest is tax deductible thus being leveraged increases cash flows to shareholders/bondholders and increase firm value
Firm can increase value by increasing debt and reducing equity
Proposition 2 - Expected return on equity increases with leverage
WACC decreases when leverage increases due to the tax advantage
Personal Taxes
Interest - Only taxed once as personal income
Dividends - Taxed twice as corporate profit and personal income
Mix of debt and equity in a company
Market value of firm derived from value of equity and debt