M&M Pizza Essay examples

1730 Words May 17th, 2016 7 Pages
FINA 351 – Managerial Finance, Chapter 13, Capital Structure, Notes
1. What is Capital Structure (CS)?
It is the mix of debt and equity on the balance sheet. The basic capital structure question is: How
much debt is right for this company? Contrary to what your momma may have taught you,
according to the so-called finance experts too little debt may be just as costly as too much debt,
because debt financing is usually the cheapest source. This is why it is often said that debt is a
two-edged sword: too much is bad but so is too little.
2. Why is CS important?
It directly impacts the cost of capital and therefore directly affects the value and profitability of
the company. For example, at one time Hershey Foods determined that its
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In other words, if you
ignore income tax and financial distress costs, your firm
should be worth the same whether it was financed with all debt or all equity. The news camera
crew folded up their cameras and said they’d get back to him. Merton decided he had somehow
missed his chance to package economic wisdom in 10-second sound-bites.

M&M Theorem and Pizza: After the ball game, the pizza man asked Yogi Berra if the pizza
should be cut into four slices as usual, and Yogi replied: “No, cut it into
eight; I’m hungry tonight.” The moral of the story? More pieces do not
mean more pizza. The main point of the M&M propositions were that if
you ignored taxes and financial distress costs, whether you get your L/T
financing from debt or equity should not matter.

5. Is there an optimum CS? If so, what about M&M’s Proposition Case I?
As illustrated, Case I
shows that the mix of
debt/equity doesn’t
matter if taxes and
financial stress costs
are ignored (the size
of a pizza doesn’t
depend on the number
of pieces). But Case
II and Case III show
that when taxes and
financial distress
(bankruptcy) costs are
considered, the value
of firm most certainly
peaks at an optimum
point. Every CFO has
a target CS for the
optimum level that
minimizes cost of
capital. An executive
at AT&T, for
example, was asked
by a reporter what its
optimum level of debt
was. The executive
answered…

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