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MM Proposition I & II with Corporate Taxes

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  • 0:04 MM Proposition 1 and 2
  • 0:55 Modigliani-Miller Theory
  • 2:33 Proposition I
  • 3:33 Proposition II
  • 6:00 Lesson Summary
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Lesson Transcript
Instructor: Sanghamitra Das

Sanghamitra has a master's in Finance and has a professional working and teaching experience of over a decade.

Corporate taxes play a major role in investment decisions and capital structure. The MM theory propositions I and II explain how the value of a firm and expected returns change due to the presence of corporate taxes.

MM Proposition 1 and 2

If you are the treasury head or a finance executive of a firm, aiming to get the ideal capital structure could be a tough task. This decision is not easy, because a firm's capital may constitute of equity alone or a mix of debt and equity. Equity capital is the fund brought forward by owners. Debt capital, on the other hand, is borrowed fund from corporate or financial institutions.

Even if you have planned to have a debt mix or a debt free capital structure, external factors like that of tax and interest rates will have different effects on the return generated by the firm. The central idea, therefore, is to identify the optimal capital structure of the firm which can match the expectations of equity holders. To help make this decision, Nobel Laureates Franco Modigliani and Merton Miller created a theory of capital structure widely known as the MM theory.

Modigliani-Miller Theory

MM theory is about the effects a firm's capital structure may have on generating returns for investors or equity holders. The definition states that ''the market value of a company is calculated using its earning power and the risk of its underlying assets and that its value is independent of the way it finances investments or distributes dividends.''

The market value of a firm helps in understanding the market capitalization, which further helps determine the overall market share of the firm. The formula to calculate the market value is to multiply the firm's number of shares outstanding by the current stock price. MM theory, however, indicates that from the equity holder's point of view, the value of a levered firm (with debt) and an unlevered firm (without debt) should be equal under certain assumptions. These assumptions are as follows:

  1. No taxes
  2. No transaction costs
  3. Equivalence in borrowing costs for both companies and investors
  4. Symmetry of market information

Miller and Modigliani theory mentions two propositions. Proposition I states that the market value of any firm is independent of the amount of debt or equity in capital structure. Proposition II states that the cost of equity is directly related and incremental to the percentage of debt in capital structure.

As a treasury or finance executive, it's important to note the impact of taxes on Proposition I and II and the benefits within. For understanding the propositions better let us proceed with two firms in the garments business: Firm X, a levered firm (with debt in capital), and Firm Y, an unlevered firm (with no debt in the capital).

Proposition I

In the first proposition, the market value (denoted as VI) of any firm is independent of the amount of debt or equity in capital structure. In a no tax scenario, the value of Firm X and Firm Y would be the same as in Proposition I with tax.

Here VlX is market value of Firm X and VlY represents the market value of Firm Y. The comparison changes in a taxable scenario, as in Proposition I with tax.

T denotes the tax rates and DY denotes the value of debt of the firm. When taxes are introduced the value of Firm Y is enhanced. This is possible due to the tax shield received from the interest payments. Whenever a firm takes a loan, it must repay installments which include interest payments. Since these payments are a part of the revenue that the firm cannot enjoy, it's also not a taxable amount but rather an expense. The portion T DY in the equation represents marginal tax rate multiplied by debt.

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