Modigliani & Miller Summary

1981 Words Nov 28th, 2011 8 Pages
The cost of capital, corporation finance and the theory of investment
Modigliani & Miller – 1958

Introduction

In a world of certainty investment decision should be in line with either profit maximization or market value maximization. - According to profit maximization, a physical asset is worth acquiring if it increases the net profit of the owners of the firm. But net profit increases only if the expected rate of return on the asset exceeds the rate of interest - According to market value maximization an asset is worth acquiring if it increases the value of the owners equity i.e. if it adds more to the market value of the firm then the costs of its acquisition.

At a micro – economic level a world of certainty has
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- Neither direct nor indirect costs associated with bankruptcy. As a consequence: - Individuals and corporations borrow at the same rate. -The providers of capital will always act in a similar ad predictable fashion.

Proposition 1

The market value of the levered firm is the same as the value of the unlevered firm.

There exist two proofs for this proposition: - Homemade leverage - Theoretical proof.

Homemade leverage

Levered companies cannot command a premium over non-levered companies as investors can create leverage themselves as well. Investors can simply sell their shares in the levered company, borrow an additional amount and invest the proceeds form the sales from the shares in the levered firm and the borrowed amount to invest in the unlevered company. Thereby depressing the prices from the levered firm and increasing the prices from the unlevered firm until an equilibrium exists.

Unlevered companies can neither command a premium over levered companies as investors can undo leverage. Investors can simply sell their shares in the unlevered companies and create their own portfolio by investing a part of the proceeds from the sale of the unlevered shares in the unlevered company and lend the other part of the proceeds. This should depress share price of the

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