Summary Modigliani & Miller

L1 Modigliani & Miller (1958) The Cost of jacket crown, Corporation Finance and the Theory of investing This article mainly discusses the court of swell, the ask harvesting necessary to tiller a neat bud comeing project worthwhile. Cost of capital includes the comprise of debt and the cost of truth. Theorist conclude that the cost of capital to the owners of a faithful is scarcely when the evaluate of interest on bonds. In a world without incredulity the rational approach would be (1) to maximize profits and (2) to maximize trade c ar for.When uncertainty arises, these statements vanish and change into a utility maximization. The goal is to get more insight in the effect of pecuniary social organization on trade valuations. I. Valuation of Securities, Leverage and the Cost of Capital A. The Capitalization roll for Uncertain Streams In the paper, M&M (1958) assume that firms evoke be divided into equivalent return classes such that the return on the takes issu ed by some(prenominal) firm in any given class is relative to the return on sh bes issued by any other firm in the same class.This implies that various cares within the same class can dissent at most by a scale factor. The significance of this self-assertion is that it permits us to clarify firms into groups where shares of different firms are homogeneous ( perfective substitutes of each other). This once again means that in equilibrium in a perfect capital market the determine per dollars worth of expected return must be the same for all shares of any given class. This leave result in the following formulas = pj = the price xj = expected return per share of the firm in class k k= expected pose of return of any share in class k 1/pk = the price which an investor has to pay for a dollars worth of expected return in the class k B. Debt Financing and its Effects on Security Prices In this case, shares get out be subject to different degrees of financial risk or leverage and he nce go forth no longish be perfect substitutes for each other. Companies will set out different proportions of debt in their capital structure and gives a different probability distribution of returns.To exhibit the mechanism find the relative price of shares under these conditions two assumption are do 1)all bonds yield a constant income per unit of time 2)bonds, like arguments, are trade in perfect market (perfect substitutes) propose 1 The value of an unlevered firm is the same as the value of a levered firm V = value of the firm S = market value of roughhewn stock D = market value of the debts X = expected return on the assets owned by the company (cost of capital)The market value of any firm is independent of its capital structure and is given by capitalizing its expected return at the rate pk appropriate to its class. This shows that the average cost of capital to any firm is completely independent of its capital structure and is equal to the capitalization rate of a small equity stream of its class. Capitalization rate (or cap rate) is a measure of the ratio amidst the lowest operating income produced by an asset (usually real estate) and its capital cost (the buffer price paid to buy the asset) or alternatively its current market value.The pure equity stream is showed in the next example If hypnotism 1 did not hold, an investor could buy and sell stocks and bonds in such a way as to exchange whiz income stream for some other stream, but selling at a lower price. It would be corrected with arbitrage. Return on a levered portfolio can be written as Y2 = return from this (levered) portfolio ? = fraction of the income available for the stockholders of the company/fraction measure shares nifty X = expected return rD2 = interest charge Return on a unlevered portfolio looks like this 1 = fraction/amount invested in stocks S1 = total stocks outstanding To see why this should be true, suppose an investor is considering buying one of the two f irms U or L. Instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the same amount of capital D that firm L does. The eventual returns to either of these coronations would be the same. Therefore, the price of L must be the same as the price of U minus the money borrowed D, which is the value of Ls debt. Proposition 2 re = ro + (ro rd) x D/E = required rate of return on equity (cost of equity) pk = cost of capital for an all equity firm r = required rate of return on borrowings (i. e. , cost of debt or interest rate) D/S = debt to equity ratio That is, the expected yield of a share of stock is equal to the appropriate capitalization rate pk for a pure equity stream in the class, plus a premium tie in to financial risk equal to the debt-to-equity ratio time the spread between pk and r. C. Some Qualifications and Extensions of the Basic Propositions Effects of Present Method of revenue enhancementing CorporationsProposition 1 b ecomes (with taxes) ? = average rate of corporate income tax ? = expected net income accruing to the jet stock holder Proposition 2 becomes (with taxes) pk can no longer be indentified with the average cost of capital when taxes come into play. Yet, to simplify things the writers will still do this. Effects of a Plurality of Bonds and Interest pass judgment Economic theory and market experience both suggest that the yields demanded by lenders tend to increase with the debt-equity ratio of the borrowing firm (or individual).The increased cost of borrowed funds as leverage increases will tend to be first by a corresponding reduction in the yield of ballpark stock. Proposition 1 remains unaffected as long as the yield curve is the same for all borrowers. However, the relation between common stock yields and leverage will no longer be the stringently linear one given by the original Proposition 2. If r increases with leverage, the yield i will still tend to rise as D/S increases, b ut at a lessen kinda than a constant rate. Yield curve D. The Relation of Propositions 1 en 2 to Current Doctrines.Proposition 1 asserts that the average cost of capital is a constant for all firms j in class k, independently of their financial structure. II. Implications of the Analysis for the Theory of Investments A. Capital Structure and Investment Policy Proposition 3 (Proposition 4 in lecture slides) A firm will exploit investment opportunities if and only if the rate of return on the investment p* is as large as or larger than pk . This will be completely unaffected by the type of security utilize to finance the investment (bonds or stocks).So the main conclusion is that companies should invest when . Capital structure is a matter of indifference and the problem of the optimal capital structure is no problem at all. B. Proposition 3 and financial Planning by Firms Misinterpretation of the scope of Proposition 3 can be avoided by remembering that this Proposition 3 tells u s only that the type of instrument used to finance an investment is irrelevant to the dubiousness of whether or not the investment is worth while.This does not mean that the owners (or managers) have no grounds whatever for preferring one financing plan to another or that there are no other policy or technical issues in finance at that level. C. The Effect of the Corporate Income Tax on Investment Decisions The cost of capital now depends on the debt ratio, decreasing , as D/V rises, at the constant rate of . frankincense with a corporate income tax under which interest is a allowable expense, gains can accrue to stockholders from having debt in the capital structure, even when capital markets are perfect. L1 Fama & French (1998) Taxes, Financin