MM: The value of the firm is always the same under diff. capital structure.
Investors receive same payoffs when 1) buys shares in a Levered firm
2) buys shares in a Unlevered firm and borrows on personal account

1. MM Proposition I (no taxes) : Value (unlevered firm) = Value (levered firm)

Homemade Leverage
If levered firm priced too high, rational investors will borrow on their personal accounts (plus personal investment) to buy shares in unlevered firm. (assumes %IR on the same terms as firms, i.e. individuals can borrow as cheaply as corporations while it's not in reality, P87)

2. MM Proposition II (no taxes) : Required return to Equityholders Rise with Leverage.

∵ Risk to Equityholders Rise with Leverage
Tables 15.2 (P85), this greater range for the EPS of the Levered firm implies greater risk for the levered firm's shareholders (not debt holders.)

Recall:

#1 Rwacc = S/(B+S) × Rs + B/(B+S) × RB
where Rs = Return on Equity = Cost of Equity or Required return on Equity = Expected earnings after interest (net income)
Equity

#2 Rwacc = R0 , where R0 is the cost of capital for an all-equity (unlevered) firm = Expected earnings to Unlevered firm
Unlevered Equity

∴ Rs = R0 + B/S (R0-RB)

	Created by Zhiying Chen about 10 years ago

Note on Untitled, created by Zhiying Chen on 15/04/2014.

Untitled