MM hypothesis

MM hypothesis states that the value of the firm and the cost of capital are influenced by the capital
structure of the firm. It means that these two do not take into account of how the firm finance its
assets. It would have no affects on the WACC and it should remain constant despite the changes
in capital structure. Moreover, since there is no transaction costs and taxes, capital structure does
not influence stock price, and hence value of the firm stays constant.
It is however dependent on the potential growth rate of the firm. If a potential investor wants to
invest, he/she would only invest if they believe that the company can grow.
Assumptions:
• No taxes
• No transaction costs.
• Symmetry of information, this means that this theory assumes both the investor and company
have the same information.
• Cost of borrowing between an investor and an individual is the same

VL - value of leveraged firm ( firms which are financed by both debt and equity)
VU - value of unleveraged firm ( firms which are only financed by equity.

Propositions with taxes

MM proposition 1 - assumes that there are no tax. This means capital structure do not influence a
firm. Also suggest that debt holder and shareholders are being paid out the same.
MM proposition 2 - assumes that financial leverage has a direct proportion to cost of equity. If debt
increases, then shareholders see a risk in and demand a higher rate of return, hence increasing
cost of equity.

Trade off theory of leverage.

Due to tax shield, interest paid on debt is tax deductible, making the bonds issues a reduce in the
company tax’s liability. Issuing dividends on equity do not. Actual rate of interest company pays is
much lower compared to the nominal interest rate due to this tax shield

Basically
In summary, the MM I theory without corporate taxes says that a firm's relative proportions of debt
and equity don't matter; MM I with corporate taxes says that the firm with the greater proportion of
debt is more valuable because of the interest tax shield.

MM II deals with the WACC. It says that as the proportion of debt in the company's capital structure
increases, its return on equity to shareholders increases in a linear fashion. The existence of
higher debt levels makes investing in the company more risky, so shareholders demand a higher
risk premium on the company's stock. However, because the company's capital structure is
irrelevant, changes in the debt-equity ratio do not affect WACC. MM II with corporate taxes
acknowledges the corporate tax savings from the interest tax deduction and thus concludes that
changes in the debt-equity ratio do affect WACC. Therefore, a greater proportion of debt lowers the
company's WACC.

Bankruptcy costs can significantly affect a company's cost of capital. When a company invests in
debt, the company is required to service that debt by making required interest payments. Interest
payments alter a company's earnings as well as cash flow.

For each company there is an optimal capital structure, including a percentage of debt and equity,
and a balance between the tax benefits of the debt and the equity. As a company continues to
increase its debt over the amount stated by the optimal capital structure, the cost to finance the
debt becomes higher as the debt is now riskier to the lender.
As we have seen, some debt is often better than no debt, but too much debt increases bankruptcy
risk. In technical terms, additional debt lowers the weighted average cost of capital. Of course, at
some point, additional debt becomes too risky. The optimal capital structure, the ideal ratio of long-
term debt to total capital, is hard to estimate. It depends on at least two factors, but keep in mind
that the following are general principles:

First, optimal capital structure varies by industry, mainly because some industries are more asset-
intensive than others. In very general terms, the greater the investment in fixed assets (plant,
property and equipment), the greater the average use of debt. This is because banks prefer to
make loans against fixed assets rather than intangibles. Industries that require a great deal of plant
investment, such as telecommunications, generally use more long-term debt.

Second, capital structure tends to track with the company's growth cycle. Rapidly growing startups
and early stage companies, for instance, often favor equity over debt because their shareholders
will forgo dividend payments in favor of future price returns. These companies are considered
growth stocks. High-growth companies do not need to give these shareholders cash today;
however lenders would expect semi-annual or quarterly interest payments.

In summary, the optimal capital structure is the mix of debt, preferred stock and common equity
that will optimize the company's stock price. As a company raises new capital it will focus on
maintaining this optimal capital structure.