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    MODIGLIANI

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    Varun_Arya_8382
    1. The Modigliani-Miller Proposition 1 states that in an efficient market without taxes or transaction costs, the value of a firm is independent of its capital structure. Whether a firm is leveraged or unleveraged, its total market value will be the same. 2. This is due to the arbitrage property - two identical assets must have the same price. If the prices differ, arbitrageurs can engage in riskless profit opportunities by buying the cheaper asset and selling the more expensive one. 3. The proposition is illustrated using two identical firms, one leveraged with debt and one unleveraged. If their values differ, arbitrageurs could profit by selling the overvalued shares

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    MODIGLIANI

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    1. The Modigliani-Miller Proposition 1 states that in an efficient market without taxes or transaction costs, the value of a firm is independent of its capital structure. Whether a firm is leveraged or unleveraged, its total market value will be the same. 2. This is due to the arbitrage property - two identical assets must have the same price. If the prices differ, arbitrageurs can engage in riskless profit opportunities by buying the cheaper asset and selling the more expensive one. 3. The proposition is illustrated using two identical firms, one leveraged with debt and one unleveraged. If their values differ, arbitrageurs could profit by selling the overvalued shares

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    1. The Modigliani-Miller Proposition 1 states that in an efficient market without taxes or transaction costs, the value of a firm is independent of its capital structure. Whether a firm is leveraged or unleveraged, its total market value will be the same. 2. This is due to the arbitrage property - two identical assets must have the same price. If the prices differ, arbitrageurs can engage in riskless profit opportunities by buying the cheaper asset and selling the more expensive one. 3. The proposition is illustrated using two identical firms, one leveraged with debt and one unleveraged. If their values differ, arbitrageurs could profit by selling the overvalued shares

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    51 views2 pages

    MODIGLIANI

    Uploaded by

    Varun_Arya_8382
    1. The Modigliani-Miller Proposition 1 states that in an efficient market without taxes or transaction costs, the value of a firm is independent of its capital structure. Whether a firm is leveraged or unleveraged, its total market value will be the same. 2. This is due to the arbitrage property - two identical assets must have the same price. If the prices differ, arbitrageurs can engage in riskless profit opportunities by buying the cheaper asset and selling the more expensive one. 3. The proposition is illustrated using two identical firms, one leveraged with debt and one unleveraged. If their values differ, arbitrageurs could profit by selling the overvalued shares

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    MODIGLIANI-MILLER PROPOSITIONS

    1
    “M-M Proposition 1: In competitive, transaction costless, information efficient markets,
    with no taxes, the market value of the firm (i.e., market value of all of its securities) is
    independent of the firm’s capital structure. That is,
    V U = V L (Where , V U is the
    value of the unlevered Firm and V L stand for the value of the levered firm).”
    [Brealey, Myers and Allen, Chapter 17]

    The proof of this proposition is based on the following arbitrage property of perfect markets.

    Arbitrage Property: Two identical assets must have the same market price. Two assets are identical
    if either can be converted into the other.

    Logic of M-M :- Let both the firms U and L be identical, with U being Unlevered firm and L being a levered
    firm.
    The two firms are identical except for the fact that L is levered. V u and VL are the value of the firm U and L
    respectively. EL and DL are the value of equity and Debt of the Firm L respectively, Hence
    VL =
    EL +
    DL .

    Assumptions of M-M: perfect and frictionless markets, no transaction costs, no default risk,
    no taxation, both firms and investors can borrow at the same rd interest rate.

     Ex. Consider two firms: one has no debt while the other is leveraged (i.e. has debts). They
    are identical in every other respect. In particular they have the same level of operating
    profits: X. Let A have 1000 shares issued at 1 euro and B have issued 500 (1 euro) shares
    and 500 euro of debt.

    Firm A Firm B
    Equity E 1000 500
    Debt D 0 500

     100 shares of B (1/5EB) give right to receive a return:


    1 1
    R  X  rd D
    5 5
     200 shares of A (1/5EA) bought using 100 euro of borrowed money (100=1/5DB) give the
    same return:
    1 1
    R X  rd D
    5 5 .
     The two investments yield the same return (and have the same financial risk) Hence 1/5 of
    A must have the same value of 1/5 of B: both shares should be equally priced. If not,
    arbitrageurs will have profitable operations at their disposal.

    Possible Possible
    Firm A Firm B equilibrium equilibrium
    Firm A Firm B
    Operating profits X 10.000 10.000 10.000 10.000
    Interests rdD  3.600  3.600
    Profits of shares X-rdD 10.000 6.400 10.000 6400
    Shares market value E 66.667 40.000 68.000 38.000
    Return on equity re 15% 16% 14,7% 16,8%
    Market value of debt D  30.000  30.000
    Market value of firm V 66.667 70.000 68.000 68.000
    Av. cost of capital ra 15% 14,3% 14,7% 14,7%
    Debt ratio D/E 0% 75% 0% 78,9%

     Firm B is overvalued with respect to A. An operator owning 1% of B can:


    1. sell his shares of B for a market value of 400;
    2. borrow 300 (i.e. 1% of the debt of B) at rd = 12%
    3. buy 1% of A for a value of 667.

     He then owns 1% of the unleveraged firm but has a debt equal to 1% of that of B. His risk
    is unchanged. Before he had an expected return of 64 (=0.16400). Now he still have a
    return of 64 (he expects to receive 100 = 0.15667 but he has to pay 36 as interests). But:
    before he had invested 400 of his money, now only 367=667300
     Hence it is profitable to sell B (the overvalued shares) and buy A (the undervalued ones).
    The price of A rises and that of B falls. The table shows a possible position of equilibrium:
    ra is the same as it should be since, by hypothesis, A and B have the same degree of risk.
    By contrast, re is higher for B because its global risk, which is equal to that of A, has to be
    shared by a lower value of equity.

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