Ramon Prat1 Revised May 8, 2023

1 The Capital Structure Decision

The wacc of the firm is given by
D E
W ACC = rd (1 − t) + re
V V

1.1 MM Proposition 1: The Market value of a firm is not

affected by the Capital Structure
The company’s choice of capital does not affect its value.
ˆ Expectations of future CF are homogeneous.
ˆ Perfect capital markets: no taxes, no transactions costs, no bankruptcy
costs, and everyone has the same information.
ˆ Investors can borrow and lent at the risk free rate.
ˆ There are no agency costs. Managers always act to maximize share-
holders returns.
ˆ Financing and operating decisions are independent or each other.
MM states that if the cash flow of two firms is the same and the risk of
business is the same, the value of the firms should be the same, otherwise
arbitrage opportunities would arise.

1.2 MM Proposition 2 without taxes: Higher Financial Lever-

age raises the cost of equity
Debtholders have prior claim so the cost of debt should be lower than the
cost of equity, but as the level of debt D increases, the cost of equity re also
increases. Shareholders ask for a compensation... and at the end of the day
the wacc remains the same. In a company financed only with equity can
take wacc = ro :
D E
W ACC = rd + re = r0
V V
D E
r0 = rd + re
D+E D+E
E D
re = r0 − rd
D+E D+E
D+E D D+E
re = r0 − rd
E D+E E

D D
re = r0 + r0 − rd
E E
D
re = r0 + (r0 − rd )
E

1
Please report comments/typos to ramon.prat@uab.cat
The cost of equity is linear on the ratio D/E, and the same is valid for βe :

D E
βa = βd + βe
V V
D
βe = βa + (βa − βd )
E

1.3 MM with Taxes

rd−af ter−tax = rd (1 − t)
MM Proposition 1 with corporate taxes (tD= tax debt shield):

VL = VU + tD

If we include the corporate taxes in the wacc formula:

D E
W ACC = rd (1 − t) + re
V V
and the cost of equity becomes
D
re = r0 + (r0 − rd )(1 − t)
E

Modigliani and Miller Propositions

Without Taxes With Taxes
Proposition I VL = VU VL = VU + tD
Proposition II re = r0 + (r0 − rd ) D
E re = r0 + (r0 − rd )(1 − t) D
E

1.4 Cost of Financial Distress

The downside of leverage is that earnings are magnified downward during
economic slowdowns and Costs of financial distress appear: investors and
creditors lost confidence, inability to refinance debt, nervous trading, lose
of customers, creditors, suppliers and employees. On the other hand, some
authors also consider that debt can have a positive side due to lower agency
and asymmetry of information costs, but will not compensate for the finan-
cial distress, spcially in high D/E ratios.

Cost Effects of Debt related to:

Taxes -
Financial distress +

2
1.5 The Optimal Capital Structure according to the Static
Trade-Off Theory
VL = VU + tD − P V (Costs of financial distress)

3
4