Am I summarizing this correctly? MM without taxes: I: capital structure is irrelevent because II: as cost of equity goes down, cost of debt goes up, and vice versa MM with taxes: I: There is an optimal capital structure because II: interest is tax deductible
Youre close, but a little off i think… No taxes MMI - capital structure is irrelevant MMII - capital structure is irrelevant. Adding more debt (cheaper financing) will increase the cost of equity, and there will be no change to WACC Taxes MMI - If there are taxes, firm value is maximized at 100% debt MMII - if there are taxes, WACC is minimized at 100% Debt There is then also the static trade off theory
Kind of…but easier to remember like this: In Prop I, you are concerned with VALUE In Prop II, you are concerned with WACC MM without tax: I: VALUE is does not change cause capital structure is irrelevant II: WACC does not change cause…(cost of equity increases proportionally as amount of Debt in capital structure increases. So WACC does not change as capital structure changes since the benefit of using debt at a lower rate is offset by the increase in the cost of equity due to more debt in cap structure) MM with tax: I: VALUE DOES change because of the tax shield of debt. Value is MAXIMIZED when Debt = 100% of capital structure II: WACC DOES change because of the tax shield of debt. WACC is MINIMIZED when Debt = 100% of capital structure Static Tradeoff: If you factor in the costs of financial distress, there is an optimal structure such that WACC is minimized and VALUE is maximized. This occurs when the marginal benefit of debt = marginal cost of financial distress. So 100% debt is not optimal, cause financial distress costs increase as your Debt level increases - and eventually, the benefit of the tax shield will be offset by the fin distress costs. So there is a “tradeoff”
Just to add, capital structure is irrelevant in MMI without taxes because investors can lever their portfolio to create whichever capital structure they prefer.
I wouldn’t look at it this way…MM looks at capital structure from a firm’s point of view just concentrate on knowing without taxes prop 1 deals with value and prop II deals with WACC
out of sheer curiosity, i searched to see if there was such as thing as a Modigliani - Miller proposition 3. apparently, there is:
Modigliani - Miller proposition III
- a firm’s total market value is independent of its dividend policy
a book im using doesnt mention this third proposition for some reason.
an interesting and quick read on the MM propositions, from the journal of international economics:
A Critical Review of MM Theorem of Capital Stricture