MM Theory

MM Proposition 1 without TAX

MM proposition 1 is to imagine two firms that are identical on the left side of the balance sheet. Their assets
and operations are exactly the same. The right sides are different because the two firms finance their
operation differently. We can view the capital structure in terms of a “pie” model. There is two possible way
of cutting up the pie between the equity slice. Pie are same for the both firms because the value of the assets
is the same.

There is another way of stating MM1 proposition, the firms overall cost of capital is unaffected by its capital
structure. The cost of debt is lower than the cost of equity is exactly offset by the increase in the cost of
equity form borrowing. In others words, the change in the capital structure weights (E/V and D/V) is exactly
offset by the change in the cost of equity (RL). So, the WACC stays same.

 A firm’s capital structure is irrelevant.

 A firm’s WACC is the same no matter what the mixture of debt and equity is used to finance the
firm.

MM Proposition 2 without TAX

This theory tells us that the cost of equity depends on three things, the required rate on the firm’s assets Ra,
the firm’s cost of debt Rd, and the firm’s debt-equity ratio D/E. MM 2 indicates that the cost of equity Re, is
given by a straight line with a slope of (Ra-Rd). The Y-intercept corresponds to a firm with a debt-equity
ratio of zero, So Ra=Re in that case.

The chat shows us that the firms raises its debt-equity ratio, the increase the leverage raise the risk of the
equity and therefore the required return or cost of equity (Re). WACC doesn’t depend on the debt equity
ratio. WACC will be same no matter what the D/E ratio is.
MM Proposition 1 with TAX

Cash Flow from Assets Firm U Firm L

EBIT 1000 1000
Taxes 300 276
Total 700 724

Cash Flow Firm U Firm L

To Stockholders 700 644
To Bondholders 0 80
Total 700 724

The debt is perpetual, the same 24 shields will be generated every year forever. The after-tax cash flow to L
will thus be the same 700 that U earns plus 24 tax shields.