Lecture Notes: Modigliani-Miller Theorem - Case 3

Review of Modigliani-Miller Propositions

• Proposition 1 & 2
  • Focused on the capital structure of a firm.
  • Examined the weighted average cost of capital (WACC).
  • Case 1: No corporate taxes and no bankruptcy costs.
  • Case 2: Included corporate taxes, no bankruptcy costs.

Introduction to Case 3

• More realistic scenario incorporating both corporate taxes and bankruptcy costs.

Types of Bankruptcy Costs

• Direct Costs:
  • Legal and administrative expenses.
  • Example: Enron spent ~$1 billion; WorldCom spent ~$600 million on bankruptcy.
  • Bondholders may face direct financial losses.
• Indirect Costs:
  • Harder to measure, potentially larger impact.
  • Management's distraction may lead to decreased sales/revenues.
  • Loss of consumer confidence (e.g., General Motors during financial crisis).
  • Employee concern can lead to loss of skilled workers.

Case 3: Bankruptcy Costs

• Debt-Equity Ratio:
  • Increase in debt ratio raises bankruptcy probability.
  • Higher bankruptcy probability leads to higher expected bankruptcy costs.
• Economic Trade-offs:
  • More debt increases interest tax yield but also bankruptcy costs, offsetting gains.
  • Excessive debt decreases firm value and increases WACC.

Graphical Representation

• Unlevered vs. Levered Firm:
  • Levered firm value equals unlevered firm value plus tax yield (corporate tax rate x debt).
  • Case 2 indicated optimal structure with all debt for lowest WACC, highest firm value.
• Inclusion of Bankruptcy Costs:
  • Early debt increase minimally impacts financial distress.
  • Excessive debt: tax yield offset by financial distress, leading to decreased value.

Optimal Capital Structure

• Graph Interpretation:
  • Aim for the peak of the curve for maximum firm value.
  • Beyond the peak, financial distress costs outweigh the tax yield.
  • Optimal structure before decline in value.

Proposition 2: Weighted Average Cost of Capital (WACC)

• Graph Analysis:
  • Case 1 (No taxes or bankruptcy costs): WACC remains unchanged.
  • Case 2 (No bankruptcy costs): Increasing debt reduces WACC.
  • Case 3 (Bankruptcy costs included): WACC eventually increases as debt benefits are outweighed by bankruptcy costs.
  • Optimal capital structure (D/E*), leads to highest firm value and lowest WACC.*

Conclusion

• Understanding trade-offs in capital structure is crucial.
• Identifying the optimal balance between debt and equity is vital for maximizing firm value and minimizing WACC.