MM theory

CFA Level II
#1

Dear:

As for MM theory, why the debt increases, cost of eqity increases. really don’t understand this concept. please give some comments.

Statement 1: According to MM’s propositions, increasing the use of cheaper debt financing will increase the cost of equity and the net change to the company’s weighted average cost of capital (WACC) will be zero.

#2

The equity has become riskier since the bond holders now have a superior claim on the assets of the company. As a result of this increase in risk, equity holder now demand a higher return on their investment. Hence the increase in the equity cost of capital.

#3

The equity has become riskier since the bond holders now have a superior claim on the assets of the company. As a result of this increase in risk, equity holder now demand a higher return on their investment. Hence the increase in the equity cost of capital.

#4

Thanks a lot

#5

Well from what I learnt in university it’s all about leverage and nothing to do with risk, since original MM don’t account for bankruptcy (risk). You’re only putting let’s say the company is worth $10. If you invest $10 and the company earns 2 dollars. This mean you get 20% return. Let’s say the company is 50% equity, 50% debt. You put in 5 dollars, but you get 2-Interest (5*interest rate). Since we know cost of debt is always less than cost of capital you return would be higher ([2-5*.19]/5 > 2/10). This means your expected to receive a higher return on your equity.

WHat Steely Dan said is one of the reason why investor want more return, but what I did is why the investor get that extra return (increase in cost of equity).

#6

Just encountered the question in the mock exam. Anyways the bankruptcy your talking about is not in Miller model. No such thing in the MM world. Bankrutcy is only taken into account by the static trade-off theory of capital structure model.

#7

I am actually a bit confused by the theory too. MM 2 theory (without taxes) states that:

As leverage increases, required return on equity increases but WACC and cost of debt remain unchanged.

  1. Does cost of debt remain unchanged because there is no cost of bankruptcy?

  2. Why is WACC unchanged? I thought it is a weighted average of both cost of equity and cost of debt, so WACC should increase as cost of equity increases

#8

  1. Yup. Normal MM does not take into effect bankruptcy stress/cost.

  2. MM1 said that regardless of capital structure value of the firm is the same right? You know that the total cashflow for each period would be the same, so in order to maintain the firm value, WACC has to be the same. If WACC was different firm value would be different.

Issuing debt is cheaper than equity because if it wasn’t people would just issue equity, while choose debt and get handcuff to annual interest. Since debt cost less, there is more amount for the equity holder to share. Equity holders’ return increase even though there is less profit there are even less people propertionally to share with. The increase in Return on equity will balance out the increase proportion of the firm in lower costing debt.

MM1 and MM2 with tax firm value change so WACC change as well. WACC decreases due to lower cost of debt (government paying a portion of your interest by letting interest be tax exempted) and since WACC decrease the cashflow is discounted less meaning firm value would increase unlike the case with no tax.