The MM, in their first paper (in 1958) advocated that the relationship between leverage and the cost of capital is explained by the net operating income approach. They argued that in the absence of taxes, a firm’s market value and the cost of capital remains invariant to the capital structure changes. The arguments are based on the following assumptions:-
(a) Capital markets are perfect and thus there are no transaction costs.
(b) The average expected future operating earnings of a firm are represented by subjective random variables.
(c) Firms can be categorized into “equivalent return” classes and that all firms within a class have the same degree of business risk.
(d) They also assumed that debt, both firm’s and individual’s is riskless.(e) Corporate taxes are ignored.
The value of any firm is established by capitalizing its expected net operating income (If Tax = 0)
VL = VU = EBIT
- The value of a firm is independent of its leverage.
- The weighted cost of capital to any firm, levered or not is
(a) Completely independent of its capital structure and
(b) Equal to the cost of equity to an unlevered firm in the same risk class.
The cost of equity to a levered firm is equal to
(a) The cost of equity to an unlevered firm in the same risk class plus
(b) A risk premium whose size depends on both the differential between the cost of equity and debt to an unlevered firm and the amount of leverage used.
As a firm’s use of debt increases, its cost of equity also rises. The MM showed that a firm’s value is determined by its real assets, not the individual securities and thus capital structure decisions are irrelevant as long as the firm’s investment decisions are taken as given. This proposition allows for complete separation of the investment and financial decisions. It implies that any firm could use the capital budgeting procedures without worrying where the money for capital expenditure comes from. The proposition is based on the fact that, if we have two streams of cash, A and B, then the present value of A +B is equal to the present value of A plus the present value of B. This is the principle of value additivity. The value of an asset is therefore preserved regardless of the nature of the claim against it. The value of the firm therefore is determined by the assets of the firm and not the proportion of debt and equity issued by the firm.
The MM further supported their arguments by the idea that investors are able to substitute personal for corporate leverage, thereby replicating any capital structure the firm might undertake. They used the arbitrage process to show that two firms alike in every respect except for capital structure must have the same total value. If they don’t, arbitrage process will drive the total value of the two firms together.