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# Learning Objectives - Understand Modigliani-Miller propositions - Analyze trade-off theory and pecking order theory - Evaluate optimal capital structure decisions ## 1. Modigliani-Miller (M&M) Propositions **M&M Proposition I (No Taxes):** Firm value is independent of capital structure.
Learning Objectives
- Understand Modigliani-Miller propositions
- Analyze trade-off theory and pecking order theory
- Evaluate optimal capital structure decisions
1. Modigliani-Miller (M&M) Propositions
M&M Proposition I (No Taxes): Firm value is independent of capital structure. VL = VU (Value of levered = Value of unlevered)
M&M Proposition II (No Taxes): Re = R0 + D/E(R0 - Rd) Cost of equity increases with leverage.
M&M with Taxes: VL = VU + D(t) Value increases with debt due to tax shield.
2. Trade-off Theory
Optimal capital structure balances:
- Benefits: Tax shield from debt
- Costs: Financial distress costs, bankruptcy costs
3. Pecking Order Theory
Firms prefer: Internal funds > Debt > Equity Due to asymmetric information (managers know more than investors).
| Concept | Description |
|---|---|
| M&M I (no taxes) | Capital structure irrelevant |
| M&M II (no taxes) | Re increases with leverage |
| M&M with taxes | Value increases with debt (tax shield) |
| Trade-off Theory | Balance tax benefits vs. distress costs |
| Pecking Order | Internal > Debt > Equity |
Q1: According to M&M with no taxes, what happens to firm value if debt increases?Nothing. Firm value is determined by assets, not how they are financed. Q2: Why does cost of equity increase with leverage?Equity becomes riskier (higher financial risk), so shareholders demand higher return. Q3: What is the tax shield from debt?Interest is tax-deductible, saving t x Interest each year. PV of tax shield = t x D. Q4: According to pecking order theory, why is equity the last choice?Managers issue equity when overvalued (asymmetric information). Investors interpret equity issuance as negative signal. Join Discord PreviousCost of Capital & WACCNextDividend Policy