M&M Theorem
Actual value of the business lies with the present value of the future cash flows
What is the M&M Theorem?
M&M Theorem (Modigliani-Miller Theorem) was developed by two economists, Franco Modigliani, and Merton Martino, in 1958. M&M Theorem states that the actual value of the business lies with the present value of the future cash flows alongside its underlying assets.
The Theorem does not consider a firm's capital structure an essential factor in calculating its net worth.
The thesis contends that, under certain circumstances, whether a business supports its expansion by borrowing, selling stock shares, or reinvesting earnings is insignificant.
The Modigliani-Miller theorem states that a company's actual economic worth is unaffected by the funding option or mix of options it chooses.
Imagine the company is a massive producer of multiple raw materials. The business person can sell them unaltered, or he may separate the fine quality raw material and sell it for much more money than the whole lot.
Consider this the equivalent of a company selling expensive, high-yield debt products.
Of course, the company would still have the low-quality raw material, which has a low product yield concentration and is sold considerably lower than the whole lot. That is equivalent to equity with a lever.
According to the Modigliani-Miller theorem, a company's capital structure has no bearing on its market value.
The theory argues that Market value is defined by the present value of expected future earnings. Since the 1950s, when the theory was first presented, it has had a significant impact.
Key Takeaways
- The Modigliani-Miller theorem states that a company's capital structure has no bearing on its market value.
- The theorem's first version assumes that businesses operate in a perfectly efficient market with no taxes, transaction costs, or bankruptcy costs.
- The theorem's second version relaxes these assumptions and accounts for the real-world factors of taxes and information asymmetry.
- In the real world, levered companies have a higher valuation than unlevered companies due to the tax shields associated with interest payments.
- The cost of equity for a company is directly proportional to its leverage level.
History of the M&M Theory
During that time, Modigliani and Miller were both lecturers at Carnegie Mellon University's Graduate School of Industrial Administration. Neither had any experience in business finance, even though they were obligated to teach corporate finance to business undergraduates.
The two scholars studied the required course materials and discovered that the concepts needed to be corrected and the content needed to be consistent. They, therefore, collaborated to rectify them.
1. First Version of the Theorem
The M&M Theorem in Perfectly Efficient Markets states that those businesses functioning in an environment with completely efficient markets do not pay taxes and assume that trading securities are done without any associated fees.
Filing for bankruptcy is an option, but there are no associated fees or costs, with perfectly symmetrical information.
The first assertion asserts that the firm's capital structure has no bearing on its value. A firm's capital structure has no bearing on its value because it is determined by the present value of expected future cash flows.
Additionally, businesses only pay taxes in markets that are 100 percent efficient. As a result, the firm with a 100% leveraged capital structure does not profit from interest payments that are tax deductible.
2. Second Version of the Theorem
According to the second tenet of the M&M Theorem, a company's cost of equity and amount of leverage are directly inversely related. Therefore, increased leverage increases a company's likelihood of default.
As a result, investors frequently demand higher equity (yield) costs to make up for the increased risk.
On the other hand, the M&M Theorem's second iteration was created to better account for actual circumstances.
The current version's assumptions indicate that businesses must pay taxes, that there are costs associated with transactions, bankruptcies, and agencies, and that information is not symmetrical.
The M&M Theorem in Perfectly Efficient Markets
The first version of the Miller-Modigliani theorem is based on the assumptions of perfectly efficient markets.
There are two propositions associated with the first version of the M&M theorem
1. Proposition-I
The first proposition speaks all about the capital structure of the company. The proposition can be portrayed in terms of the formula:
VL= VU
where,
- VL = value of the unlevered firm (composed of just equity)
- VU = value of the levered firm (combination of debt & equity)
It claims that the capital structure of a company does not have any effect on its value. The rationale behind this claim is based on the DCF valuation of a company, i.e., the value of the company is equal to its present value of future cash flows.
In addition, in perfectly efficient markets, the company isn't bothered about taxes. Thus, a company with huge leverage on its capital structure would not receive any benefits from its interest payments.
2. Proposition-II
The second proposition compares the company's cost of equity to its leverage position.
As the leverage increases, the probability of default increases for the company, which eventually leads investors to demand a higher cost of return for the extra risk.
The formula associated with the second proposition is:
rE= ra + D/E ( ra - rD )
where,
- rE = cost of levered equity
- ra = cost of unlevered equity
- rD = cost of Debt
- D/E = debt to equity ratio
M&M Theorem in the Real World
We do not live in a hypothetical world. Hence, the second version of the M&M theorem was created, which was more suited to the real-case scenarios of taxes and information asymmetry.
Again, there are a couple of propositions associated with the M&M Theorem in the real world.
1. Proposition-I
The first proposition states that the tax shields associated with tax-deductible interest payments give levered companies a higher valuation than unlevered companies.
Since the DCF valuation method is based on the cash flow, which in turn is affected by the interest payments, the levered company has a higher value than its counterpart.
The formula associated with the proposition is:
VL = VU + tC x D
where,
- tC = Tax Rate
- D = Debt
2. Proposition-II
The second proposition states that the leverage level and cost of equity for a company are directly proportional. The tax shields have a huge effect on the cost of equity by making it insensitive to leverage.
Any increase in the debt ultimately means that there is a higher risk of default by the company; however, the company does not get a negative reaction from the investors as it creates tax shields that boost its value.
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