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Guide/Corporate finance

Capital structure and the Modigliani–Miller theorems

Lesson 5 of 8 · 1 min read

The lesson "The weighted average cost of capital" took the mix of debt and equity as given. A firm can change that mix: borrow and buy back shares, or issue shares and repay debt. This lesson asks whether doing so changes the value of the firm and its cost of capital. The answer, due to Modigliani and Miller, is no in a world without taxes, and yes, through the tax shield, once corporate taxes are included.

Capital structure and leverage

A firm's capital structure is its mix of debt DDD and equity EEE. It is described by the debt ratio D/VD/VD/V, with V=D+EV = D + EV=D+E, or equivalently by the debt-to-equity ratio D/ED/ED/E. The two are linked by

DE=D/V1−D/V.\frac{D}{E} = \frac{D/V}{1 - D/V}.ED​=1−D/VD/V​.

A firm that uses debt is called levered; the same firm with no debt is unlevered. Using more debt is called increasing leverage. Throughout the lesson the firm's operations, and therefore its operating cash flows, stay fixed. Only the way those cash flows are split between lenders and shareholders changes.

Assumptions

Modigliani and Miller work in an idealised market. State the assumptions explicitly, because each conclusion below depends on them:

  • No taxes (relaxed later in the lesson).
  • No costs of bankruptcy or financial distress.
  • Investors and firms can borrow and lend at the same rate.
  • Everyone has the same information, and there are no transaction costs.

Firm value without taxes

Let VUV_UVU​ be the value of the unlevered firm and VLV_LVL​ the value of the same firm with debt. Modigliani–Miller Proposition I states that without taxes

VL=VU.V_L = V_U.VL​=VU​.

The argument is a no-arbitrage argument. Owning all the debt and all the equity of the levered firm gives exactly the operating cash flows of the firm, which are the same with or without debt. Two claims to the same cash flows must have the same price. A shareholder who wants more leverage can also borrow personally and buy more shares ("homemade leverage"), so the firm cannot create value by doing the borrowing for them.

A fair picture is a pizza: cutting it into more or fewer slices does not change how much pizza there is.

The cost of equity rises with leverage

Write rUr_UrU​ for the return investors require on the unlevered firm, the unlevered cost of capital. It reflects only the business risk of the operations. Since VL=VUV_L = V_UVL​=VU​ and the cash flows are unchanged, the return on the whole levered firm is still rUr_UrU​, so its WACC (without taxes) equals rUr_UrU​:

rU=EV rE+DV rD.r_U = \frac{E}{V}\,r_E + \frac{D}{V}\,r_D.rU​=VE​rE​+VD​rD​.

Multiply by V/EV/EV/E and solve for the cost of equity rEr_ErE​:

rE=rU VE−rD DE=rU(1+DE)−rD DE=rU+(rU−rD) DE.r_E = r_U\,\frac{V}{E} - r_D\,\frac{D}{E} = r_U\Big(1 + \frac{D}{E}\Big) - r_D\,\frac{D}{E} = r_U + (r_U - r_D)\,\frac{D}{E}.rE​=rU​EV​−rD​ED​=rU​(1+ED​)−rD​ED​=rU​+(rU​−rD​)ED​.

This is Modigliani–Miller Proposition II. Debt is cheaper than equity, rD<rUr_D < r_UrD​<rU​, but borrowing more does not lower the WACC: the shareholders bear the same business risk on a smaller stake, so their required return rEr_ErE​ rises exactly enough to offset the cheaper debt.

Example: rU=10%r_U = 10\%rU​=10%, rD=5%r_D = 5\%rD​=5% and D/V=40%D/V = 40\%D/V=40%, so D/E=0.4/0.6≈0.667D/E = 0.4/0.6 \approx 0.667D/E=0.4/0.6≈0.667. Then rE=10%+5%×0.667≈13.33%r_E = 10\% + 5\% \times 0.667 \approx 13.33\%rE​=10%+5%×0.667≈13.33%, and the WACC is 0.6×13.33%+0.4×5%=10%=rU0.6 \times 13.33\% + 0.4 \times 5\% = 10\% = r_U0.6×13.33%+0.4×5%=10%=rU​.

Without taxes, capital structure is irrelevant: VL=VUV_L = V_UVL​=VU​, the WACC equals rUr_UrU​ at every debt ratio, and rE=rU+(rU−rD) D/Er_E = r_U + (r_U - r_D)\,D/ErE​=rU​+(rU​−rD​)D/E.

Corporate taxes and the tax shield

Now add a corporate tax rate ttt. As in "The weighted average cost of capital", interest is deductible, so a firm with debt DDD at rate rDr_DrD​ saves t rDDt\,r_D DtrD​D in tax every year. Assume the debt is perpetual: the firm keeps the amount DDD outstanding forever. The tax savings are then a perpetuity, and discounting it at rDr_DrD​ (it is as safe as the interest payments) gives the value of the tax shield:

PV(tax shield)=t rDDrD=t D,VL=VU+t D.\text{PV(tax shield)} = \frac{t\,r_D D}{r_D} = t\,D, \qquad V_L = V_U + t\,D.PV(tax shield)=rD​trD​D​=tD,VL​=VU​+tD.

Example: an unlevered firm worth VU=1000V_U = 1000VU​=1000 that borrows D=400D = 400D=400 at t=25%t = 25\%t=25% is worth VL=1000+0.25×400=1100V_L = 1000 + 0.25 \times 400 = 1100VL​=1000+0.25×400=1100. The extra 100 is money that no longer goes to the tax authority.

The formulas for the costs of capital change accordingly. With perpetual debt they become

rE=rU+(rU−rD)(1−t) DE,WACC=EV rE+DV rD(1−t)=rU(1−t DV).r_E = r_U + (r_U - r_D)(1 - t)\,\frac{D}{E}, \qquad \text{WACC} = \frac{E}{V}\,r_E + \frac{D}{V}\,r_D(1 - t) = r_U\Big(1 - t\,\frac{D}{V}\Big).rE​=rU​+(rU​−rD​)(1−t)ED​,WACC=VE​rE​+VD​rD​(1−t)=rU​(1−tVD​).

With the numbers above (rU=10%r_U = 10\%rU​=10%, rD=5%r_D = 5\%rD​=5%, D/V=40%D/V = 40\%D/V=40%) and t=25%t = 25\%t=25%:

Worked example

Costs of capital with corporate taxes

  1. The debt-to-equity ratio from D/VD/VD/V.

    DE=D/V1−D/V\displaystyle \frac{D}{E} = \frac{D/V}{1 - D/V}ED​=1−D/VD/V​=0.667
  2. Proposition II with taxes: the cost of equity.

    rE=rU+(rU−rD)(1−t) DE\displaystyle r_E = r_U + (r_U - r_D)(1 - t)\,\frac{D}{E}rE​=rU​+(rU​−rD​)(1−t)ED​=12.5%
  3. The after-tax cost of debt.

    rD (1−t)\displaystyle r_D\,(1 - t)rD​(1−t)=3.75%
  4. The WACC from the weighted average.

    WACC=EV rE+DV rD(1−t)\displaystyle \text{WACC} = \frac{E}{V}\,r_E + \frac{D}{V}\,r_D(1 - t)WACC=VE​rE​+VD​rD​(1−t)=9%
  5. The shortcut gives the same number.

    rU(1−t DV)\displaystyle r_U\Big(1 - t\,\frac{D}{V}\Big)rU​(1−tVD​)=9%

The WACC is below rU=10%r_U = 10\%rU​=10% and now falls as leverage rises.

The next figure draws these values as bars for an unlevered firm worth VU=100V_U = 100VU​=100. The upper bar is the unlevered firm, all equity. The lower bar is the same firm with debt, split into debt DDD and equity EEE, and the hatched slice beyond the dashed mark at VUV_UVU​ is the tax shield t Dt\,DtD. Drag the boundary between debt and equity (or focus it and use the arrow keys) to set D/VD/VD/V between 0 and 80%; the bars underneath show rEr_ErE​, the after-tax cost of debt and the WACC against the dashed mark at rUr_UrU​. At D/V=40%D/V = 40\%D/V=40% the firm carries D≈44.4D \approx 44.4D≈44.4, is worth VL≈111.1V_L \approx 111.1VL​≈111.1 and the readouts repeat 12.5%12.5\%12.5% and 9%9\%9%. Switch the tax to "None": the lower bar keeps the length of the upper one however much debt you add, which is Proposition I, while rEr_ErE​ still climbs.

Firm value split into debt and equity (MM with taxes)Open in Capital Structure →
Drag the boundary, or focus it and use the arrow keys.
Unlevered
Levered
V_U = 100
  • Debt D
  • Equity E
  • Tax shield tD
Cost of equity r_E
12.50%
After-tax cost of debt
3.75%
WACC
9.00%
Debt ratio D/V
40%
Firm value V_L
111.11
Tax shield tD
11.11
Cost of equity r_E
12.50%
WACC
9.00%

Costs of capital against leverage

The figure plots, against the debt ratio D/VD/VD/V from 0 to 80%, the cost of equity rEr_ErE​, the after-tax cost of debt rD(1−t)r_D(1 - t)rD​(1−t) and the WACC, all under the formulas with taxes. Sliders set rUr_UrU​, rDr_DrD​, the tax rate ttt and the chosen D/VD/VD/V, which is marked by a reference line; the readouts give rEr_ErE​, the after-tax cost of debt and the WACC there. At the defaults (rU=10%r_U = 10\%rU​=10%, rD=5%r_D = 5\%rD​=5%, t=25%t = 25\%t=25%, D/V=40%D/V = 40\%D/V=40%) they show 12.5%12.5\%12.5%, 3.75%3.75\%3.75% and 9%9\%9%, as computed above. Set ttt to zero and the WACC line becomes flat at rUr_UrU​: that is Proposition I and II without taxes. Raise ttt and note that the WACC slopes down more steeply.

Costs of capital against leverage (MM with taxes)Open in Capital Structure →
10.00%
0.040.15
5.00%
0.020.08
25%
00.4
40%
00.8
Cost of equity r_EAfter-tax cost of debtWACC
Cost of equity r_E
12.50%
After-tax cost of debt
3.75%
WACC
9.00%

Limits of the result

Taken literally, the version with taxes says a firm should be financed almost entirely by debt. Real firms are not, because the assumptions fail at high leverage. Heavily indebted firms face costs of financial distress: higher borrowing rates, lost customers and suppliers, legal costs in bankruptcy. The trade-off view of capital structure balances the tax shield against these costs, which suggests a moderate debt ratio at which firm value is highest. The figure and the lab show only the tax side of this balance.

Summary

  • Capital structure is the mix of debt and equity, measured by D/VD/VD/V or D/ED/ED/E; operating cash flows do not depend on it.
  • Without taxes, VL=VUV_L = V_UVL​=VU​ and the WACC equals the unlevered cost of capital rUr_UrU​ at any leverage (Proposition I).
  • The cost of equity rises with leverage: rE=rU+(rU−rD) D/Er_E = r_U + (r_U - r_D)\,D/ErE​=rU​+(rU​−rD​)D/E (Proposition II).
  • With corporate taxes and perpetual debt, VL=VU+tDV_L = V_U + tDVL​=VU​+tD, rE=rU+(rU−rD)(1−t) D/Er_E = r_U + (r_U - r_D)(1 - t)\,D/ErE​=rU​+(rU​−rD​)(1−t)D/E and WACC=rU(1−t D/V)\text{WACC} = r_U(1 - t\,D/V)WACC=rU​(1−tD/V).
  • Costs of financial distress, which the model leaves out, limit how much debt is worth taking on.

The next lesson, "Discounted cash flow valuation", uses the WACC to value an entire firm from its free cash flows.

Try itSee how leverage moves the cost of equity, the WACC and firm value in the Capital Structure lab →
2 questions on this lesson at the end of the series →
← PreviousThe weighted average cost of capitalNext →Discounted cash flow valuation
Connections
Capital structure and the Modigliani–Mil…
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Labs for this lesson
Capital StructureCost of Capital (WACC)