Back To CourseCorporate Finance: Help & Review
12 chapters | 182 lessons
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Sanghamitra has a master's in Finance and has a professional working and teaching experience of over a decade.
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.
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:
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).
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.
Proposition II mentions the cost of equity is directly proportional to the percentage of debt in capital structure. Let us continue with the example of Firm X with debt and Firm Y without debt but only equity. In a no tax scenario expected return on equity of Firm X can be calculated based on the following formula as shown in Proposition II without tax.
RE in the equation represents the cost of equity. While this is cost for the firm, it's the expected return for the equity holders or investors. Let us assume RE for Firm Y to be 10 percent. RD represents the cost of debt, and this is the return for the lending institution. Let us assume it to be at 5 percent. In our case example, we have decided Firm X is a levered firm and has a mix of both debt and equity in the proportion of 35:65. This proportion is commonly known as the debt to equity, or D/E, ratio. Imagining a world without tax, Proposition II equation turns out as follows:
RE Firm X = 10 + (35/65) * (10 - 5) = 12.7%
Now we need to compare the returns of Firm X under corporate tax. With the element of tax, the required return for Firm X changes as shown in Proposition II with taxes. Here TX denotes the tax rate, which is at 30%. Expected return on equity on Firm X can be calculated as follows:
RE Firm X = 10 + (35/65) * (10 - 5) * (1 - 0.30) = 11.88%
On a taxable scenario expected return on equity portion of a levered firm reduces. Now let us consider a situation where the tax rate decreases to 20 percent. The expected return on Firm X can be calculated as follows:
RE Firm X = 10 + (35/65) * (10 - 5) * (1 - 0.15) = 12.28%
The expected return on equity of the levered firm, Firm X, increases significantly with decrease in the tax rate. Tax rates are fixed by the federal law and there's nothing in the firm's capacity to change or influence it. Therefore, as a treasury manager or a finance executive, the road to incremental return on equity is by balancing the debt and equity proportions in the firm.
MM theory was formulated under certain assumptions that do not exist in the real world. This is why Proposition I and Proposition II are valid with corporate taxes. Proposition I without taxes shows the equality of value between a levered and unlevered firm under zero tax. But with the prevalence of taxes, the value of the levered firm is enhanced by the tax shield received due to debt repayments.
MM Proposition II without taxes shows cost of equity of the levered firm as a function of cost of debt and equity of the unlevered firm. Thus, with taxes in the Proposition II the cost of debt is influenced by a tax shield that the levered firm can enjoy, as this will bring down the cost of equity for the levered firm. Thus, taxes in the real world make a positive impact for a firm with leverage or debt.
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Back To CourseCorporate Finance: Help & Review
12 chapters | 182 lessons
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