Think of the financial manager as taking all of the firms real assets and selling them to investors as a package of securities. Some financial managers choose the simplest package possible: all- equity financing. Some end up issuing dozens of debt and equity securities. The problem is to find the particular combination that maximizes the market value of the firm.

Modigliani and Millers (MMs) famous proposition 1 states that no combination is better than any otherthat the firms overall market value (the value of all its securities) is independent of capital structure. Firms that borrow do offer investors a more complex menu of securities, but investors yawn in response. The menu is redundant. Any shift in capital structure can be duplicated or undone by investors.

Question to discuss:

Why should they pay extra for borrowing indirectly (by holding shares in a levered firm) when they can borrow just as easily and cheaply on their own accounts?

MM agree that borrowing raises the expected rate of return on shareholders investments. But it also increases the risk of the firms shares. MM show that the higher risk exactly offsets the increase in expected return, leaving stockholders no better or worse off.

Discuss - MM model

Proposition 1 is an extremely general result. It applies not just to the debtequity trade- off but to any choice of financing instruments. For example, MM would say that the choice between long-term and short-term debt has no effect on firm value.

The formal proofs of proposition 1 all depend on the assumption of perfect capital markets. MMs opponents, the traditionalists, argue that market imperfections make personal borrowing excessively costly, risky, and inconvenient for some investors. This creates a natural clientele willing to pay a premium for shares of levered firms. The traditionalists say that firms should borrow to realize the premium.

But this argument is incomplete. There may be a clientele for levered equity, but that is not enough; the clientele has to be unsatisfied.There are already thousands of levered firms available for investment.

Is there still an unsatiated clientele for garden-variety debt and equity?

My views: I doubt it. Do you agree?

Proposition 1 is violated when financial managers find an untapped demand and satisfy it by issuing something new and different. The argument between MM and the traditionalists finally boils down to whether this is difficult or easy. We lean toward MMs view: Finding unsatisfied clienteles and designing exotic securities to meet their needs is a game thats fun to play but hard to win.

If MM are right, the overall cost of capitalthe expected rate of return on a portfolio of all the firms outstanding securitiesis the same regardless of the mix of securities issued to finance the firm. The overall cost of capital is usually called the company cost of capital or the weighted- average cost of capital (WACC). MM say that WACC doesnt depend on capital structure. But MM assume away lots of complications. The first complication is taxes. When we recognize that debt interest is tax-deductible, and compute WACC with the after-tax interest rate, WACC declines as the debt ratio increases