The contribution of MM theory

Introduction
In the process of development of modern financial theory, MMs capital structure
irrelevant theory plays a significant core role. The ModiglianiMiller theorem (also
called capital structure irrelevance principle) was published in 1958 by Miller and
Modigliani in the article American Economic Review when they were both professors
at the Graduate School of Industrial Administration (GSIA) of Carnegie Mellon
University. The first of MM theory does not consider the influence of income tax, and
the conclusion is the total value of the enterprise is not influenced by the capital
structure. Then, the theory of made revisions, joined the income tax, so that the
conclusion is the enterprise's capital structure affect the enterprise value, debt
management will bring the company tax saving effect. This theory for research on
capital structure provides a useful starting point and the analysis framework.
This paper is going to introduce the development of MM model. Firstly, the early MM
theory about capital structure is irrelevant companys value. Secondly, the modified
MM model added the tax element into MM theory. Thirdly, the complement of MM
theory makes it more practical. Finally, case analysis by company Mulberry and
company National Grid will be conducted.
In the article they conducted MM theory proposition 1: in a perfect capital market,
the total value of a firm is equal to the market value of the total cash flows generated
by its assets and is not affected by its choice of capital structure.(Watson and Head,
2010) Although it is true that there is no prefect market in real world, but all scientific
theories start with an assumption as a perfect market. With the approach of research
and application of theories, people will reevaluate how closely the assumption related
to the real situation. So before the theory itself, the perfect capital market is defined
with such natures:

1.

Both individual investors and firms can borrow with the same level interest, and
they can trade the same set of securities at competitive market prices equal to the

2.

present value of their future cash flows.

There are no taxes, transaction costs, or issuance costs and the bankruptcy could

3.

be ignored as they can always raise additional fund to avoid bankruptcy.

A firms financing decisions do not change the cash flows generated by its
investments, nor do they reveal new information about them.

In the proposition 1 we mentioned above, we can include that a companys WACC

remains the same with any kind of level of gearing, and there would be no optimal
capital structure as the market value will remain the same. Here they argued that the
market value of a company and cost of capital are independent of capital structure.
Cost of capital (%)

Ke

WACC

Kd
0

Level of gearing

Miller and Modiglianis net operating income approach to capital structure

(Resource: Watson and Head, 2010, P285)

From the diagram above we can find that, the cost of equity (Ke) presenting the
financial risk faced by shareholders will increase at a fixed ratio which means that
there is a linear relationship between the level of gearing and the cost of equity. As we
said before, bankruptcy will not be taken into consider that the cost of debt (Kd) will
be constant and the line should be horizontal. Point A could present a company
financed by pure equity. With level of gearing increasing, the cost of equity increases
exactly the same degree that can offset the cheaper debt finance. Therefore the WACC
remains the same and so does market value of the firm.
2

Miller and Modigliani supported their argument that capital structure was irrelevant in
determining the market value and average cost of capital of a company by using
arbitrage theory.
With arbitrage theory, Miller and Modigliani argued that two companies identical in
every way except for their gearing levels should have identical average costs of
capital and hence should not have different market values (Watson and Head, 2010).
Firm U

Firm L

1000

1000

150

1000

850

Cost of equity

10%

11%

Market value of equity()

10000

7727

Market value of debt ()

3000

Total value of company

10000

10727

WACC

10%

9.3%

Net operating income()

Interest

on

debt

(5%3000)
Earnings

available

to

shareholders()

Arbitrage process using two companies

(Resource: Watson and Head, 2010, P286)

We take an example that there are two firms U and L, who share the same net
operating income and the level of business risk. But Firm U is financed by pure equity
and Firm L has a debt of 3000 with a 5% interest rate.
From the table we can find that Firm L has a higher cost of equity but lower WACC.
Since the two firms have the same business risk and net operating income they are
supposed to have the same market values and WACC, but we find it is not true in real
case. With an assumption that investors can borrow at the same rate, they can make a
profit by using the arbitrage theory.
If an investor owned 1 percent of the equity of the geared Firm L (77.27), he could:
3

 Sell his shares in Firm L for 77.27

Borrow 30 at 5%
Buy 1 percent of the shares in company A for 100. And have 7.27 left.
If the investor dont take the action to sell shares of Firm L, the return from company
B =11%77.27=8.50
While after the investment above, return from Firm U=10% 100= 10.00
Less: financial cost, interest on debt =5%30
Net return

= (1.50)

= 8.50

During this investment, there is a 7.27 left within the trading actions of selling Firm
L and buy Firm U. This risk-free surplus of 7.27 is called an arbitrage profit. It is a
good opportunity for investor to repeat the investment until it disappeared. But there
are several assumptions supporting this arbitrage theory, which do not exist in real
market, and we should consider them along with investment. First, individual
investors will not have the same interest rate as companies, and personal borrowings
are thought to be more risky in real market. Second, transaction costs should be
considered when repeating the process. Share price of Firm L will drop with the
selling action of investors and they would find the 7.27 will decrease till zero.
According MM 1, the capital choice does not change the firms value. However, in
real world the unreasonable capital structure does provide the risk. According MM
proposition 1, the value of equity and debt equal the total value of firm if the firm is
levered. The total market of value of the firms securities is equal to the market value
of its assets, whether the firm is unlevered or levered
E+D=U=A
E
E+ D

RE

D
R
D+ E D =

RU

If we solve the equation for RE, we can get the return of levered equity:

RE

RE

D
+ E

U R D
(
)
R
4

The cost of levered equity is equal to the cost of capital of unlevered equity plus a
premium that is proportional to the market value debt-equity ratio. (Berk and
Demarzo, 2007, 438) We can figure out the as the debt to equity ratio increasing, the
return of equity will increase as well. Because the cost of debt is low, the increasing
cost of equity was offset by the increasing tax reduction. So the weight average cost
of capital tends to be constant.

As just discussed above, all of situations are happened underlying the several
assumptions. However, in fact, corporate tax exists in most of countries. Hence, the
things go to different from the MM theory I if considering the existence of corporate
tax. In most of countries, such as UK, US and so on, interest payments on debt are
tax- deductable. Conversely, the dividends which paid to shareholder cannot obtain
the tax deductable. Assuming there are two companies: company A is an unleveraged
firm which total capital firm with no debt and company B is a leverage firm which has
issued perpetual debt and has to pay interest 500 pound every year. Hypothesis both
of them will earn 1500 pound. The following table shows the benefit of tax-shield
clearly.
Item

Firm A

Firm B

Earnings

1500

1500

Interest on debt

500

Taxable income

1500

1000

Corporate tax (30%)

450

300

After-tax earning

1050

700

Bondholders

500

Shareholders

1050

700

Total

1050

1200

Tax shield

500

Cash to investors

According to the table, the leverage company B which takes the debt financing has
the tax shield 500 pound. The value of the levered company is equal to the value of
the unlevered company plus the interest tax shield on debt:

VL=VU+TC *D
Where

VL is the value of a levered firm.

VU is the value of an unlevered firm.

TCD is the tax rate (TC) x the value of debt (D)

the term TCD assumes debt is perpetual

So tax shield can increase companys value. Because, the debt interest can be offset
tax paid. Therefore financial leverage reduced firms after-tax weighted average of
capital costs.
Ke = Ka + D/E ( Ka - Kd ) (1- TC)
So WACC2 = (1- TC) Kd (D/D+E) + Ke (E/D+E)
Obviously, WACC2 is smaller than WACC1 which mentioned in MM theory I.
Cost of capital (%)

Ke

Kd
WACC

Kd(1-CT)

Level of gearing

Miller and Modigliani 2, incorporating corporate taxation

(Resource: Watson and Head, 2010, P288)
6

As the above chart illustrated, the cost of debt curve (Kd) from MM first model shifts
downwards to reflect the lower after- tax cost of debt finance (Kd( 1-CT)). As a
company gears up its WACC curve now falls. (Denzil Watson and Antony Head,
2010,P287)
Predictably, the more debt the company has, the more tax shields the company gains,
and the larger value the company is. Therefore, on the basis of the original MM model
after add corporate tax adjustment, we can draw the conclusion: the existence of tax is
a significant performance of imperfect capital market, and when capital market is not
mature, capital structure change will affect the company's value, which means the
value of the company and the cost of funds will change along with capital structure
changes. Hence, the company has leverage worth more than the value of the company
without leverage (the value of company with liabilities would exceed the value of the
company without liabilities) the more debt, the difference is bigger. Finally, when
liabilities go to be 100%, the company value is maximums.
Definitely, if only considering tax- shield benefit, the higher gearing level, and the
more benefit company can gain, consequently, all of the firms would love to increase
their debt to 100% in order to obtain the largest tax deductable.
However, in reality market, situation is more complex. The high debt will bring a lot
of problems along with the increasing of gearing level, such as bankrupt, agency
problem, tax exhaustion and so on. As the debt proportion increase, the risk of the
capital increase.
In the real world, the capital market is not perfect. It is obviously that the companies
cannot take the capital structure with all debt. The MM theory still gives manager the
implication about reasonable capital structure. In reality, at high level of gearing, there
is a significant possibility of a company bankruptcy, shareholder require a high rate
of return to cover the bankruptcy risk. Although the firms get benefit from debt
because of tax, it is impossible to take the capital structure with all debt.
There are two kinds of costs bankruptcy costs which are direct bankruptcy costs and
indirect bankruptcy costs. Direct bankruptcy cost includes the costs of paying lenders
higher rates of interest to compensate them for higher risk. If we consider the
liquidation, the cost of employing lawyers and accountants to manage the liquidation
7

process is involved as well. Indirect bankruptcy includes loss of sales and goodwill
as a consequence of operating the company at extreme levels of financial distress. If
we consider the liquidation, the cost of having to sell assets at below their market
value is involved. (Watson and Head, 2010, P288)
The following graph presents the tax shield benefit and the bankruptcy costs as the
increasing high level of gearing.
Market value with tax benefits

Market value of firm

C
B

Market value
Allowing for
Financial distress

D
A

Market value of all-equity firm

Level of gearing

Miller and Modigliani 2, incorporating bankruptcy risk

(Resource: Watson and Head, 2010, P298)

When the company increase the level of gearing which replace the equity with the
debt, the market value will increase because the benefit from its tax shield. The
vertical distance AC is the increased market value because of tax shield. However, if
the level of gearing is too high that reach point X, the firm cannot ignore the
bankruptcy costs. Therefore the market value will be driven down by the bankruptcy
costs since point X. If the firm continues to chase the high return with high risk which
the level of gearing reaches point Y, the market value will decrease sharply to offset
the benefit of tax shield. The vertical distance of line BC is the cost of bankruptcy
risk. So the net benefit of the geared firm is the vertical distance of line AB. Level of
gearing Y with the market value of AB is the optimal gearing level. Gearing levels
8

beyond Y will increase the value of tax shield but this is more than cancelled out by
increasing bankruptcy costs, leading to a decline in the value of company. In real
word the bankruptcy costs are difficult to measure and the point Y is also not clear
depends different industry and economic situations. But the graph combines the tax
shield and bankruptcy costs still very helpful for firm to find out a relatively optimal
capital structure.
Mulberry

National Grid

10 000

09 000

10 000,000

09000,000

Equity

26456

24384

4,211

3,984

Debt(long)

132

22,139

22,673

D/(D+E)

0.005

84.02

85.05%

TAX

2124

1596

804

472

Tax rate

41.7%

38.2%

36.66%

33.86%

11.3

10.8

Return

on

equity
Interest rate

12%

(Resource: Mulberry annual report 2010, National Grid annual report 2010)

Mulberry Group majority businesses are both manufacture and retail by its own
stores. The brand focuses on luxury leather bags and also includes women clothing
and accessorize. According the UK industrial sector of clothing statistic, the capital
gearing ratio of clothing industry is generally 31. (Watson and Head, 2010,P279) So
this is the most important reason that Mulberry group with all equity capital structure
has been chosen.
According MM theory 2, the tax benefit is able to increase market value. Mulberry
took all-equity capital structure in 2010, a huge amount which is 2124000, take
41.7% of the before tax profit. If Mulberry replaces the equity with debt, the firm will
get more profit due to tax shield.
National Grid plc engages in the ownership and operation of regulated electricity and
gas infrastructure networks in the United Kingdom and the United States. The
company has high voltage electricity transmission network in England, Scotland, and
9

Wales, as well as in New York, Massachusetts, New Hampshire, Rhode Island, and
Vermont; gas national transmission system in Great Britain; electricity interconnector
with France; and storage facilities for liquefied natural gas (Yahoo finance, 2010).
Comparing with Mulberry, National grid takes the market structure with high level of
gearing. The relative reasonable debt make the company pay less tax, which take
36.66% of the before tax profit. However, National Grids capital structure with high
level of gearing also has problems. The major risk of this company is high level debt
leading to the interest risk. Interest rate risk arises from huge amount of borrowing.
Borrowing issued at variable rates expose National Grid to cash flow interest risk.
Borrowing issued at fixed rates expose National Grid to fair value interest rate
risk.(National Grid annual report, 2010) Therefore one of the objectives is to
manage associated financial risk, in form of interest rate. National Grid managed the
interest by managing the interest cover ratio which is EBIT/Interest. The interest
cover rate of 2009 was 3.1. At the end of 2009, the company made a long term target
interest cover was 3.5 in 2010. Because the company focus on reducing debt, the
interest cover rate of 2010 has been 3.9. We can use MM theory as a basic strategy.
We can also add our own idea to complement it. In real world, after the basic
understanding about MM theory and its own capital situation, we manage the capital
issue by choosing some ratios such as interest cover ratio.

10

Conclusion
Although MM theories have many assumptions, it still gives firms implications about
reasonable capital structure. Before the MM theories, people usually use the average
and marginal cost of capital to consider the cost of capital. Average and marginal cost
of capital method failed to consider the different characteristic of different capital.
Some people think MM theories fail to consider bankruptcy costs, agency costs and
tax exhaustion and so on. However the MM theories are the basic theory of the other
modern theories. MM theory plays an important role on capital structure. People can
implement it and make it tend to be perfect.

11

Reference
Anon. (2010), Mulberry annual report,

[valid online]

http://www.mulberry.com/#/discovermulberry/investorrelations/companyreports

[access date: 19/03/2011]

Berk, J. and DeMarzo, P. (2007): Corporate Finance (international edition). Boston:
Pearson Education.
Denzil, W., Antony, H., (2010): Corporate Finance (5th ed). London: Prentice Hall
National Grid (2010), Annual report and accounts 2009/10: shaping the future, [valid
online]: http://www.nationalgrid.com/annualreports/2010/ [access date: 19/03/2011]
Yahoo

Finance

(2010),

National

Grid

plc

profile,

[valid

online]:

http://finance.yahoo.com/q/pr?s=NGG+Profile [access date: 19/03/2011]

12