Question

Financing corporate purchases and overall capital budgeting usually requires the finance manager to assess tax rates, dividend payout policy, weighting of capital sources, and more. However, the Modigliani and Miller propositions state that, in most situations, it does not matter if the firm's capital is raised by issuing stock or selling debt. As a student you might assume studies of capital budgeting strategies will no longer be reviewed in coursework. Before coming to that conclusion (as stated above), please discuss the principles presented by Modigliani and Miller and explain your agreement or disagreement.

Answer 1

The problem with the M&M proposition is that taxes are not included and it also doesn't consider the increase in risk due to higher debt.

Debt decreases the company's WACC because the after tax cost of debt is usually much lower than the cost of equity, e.g. a 10% pretax cost of debt results in a 7.9% after tax cost of debt. Also, if the company the higher the debt ratio and everything goes as planned, the EPS should be higher.

But nothing is free in the world, and a high debt ratio = higher risk. Remember that investors are risk averse, and the higher the risk, the higher the cost of equity. The risk of not being able to generate enough income to pay interests is always real, and it scares investors.

So it is not the same to finance a company using debt or equity. The problem with theoretical models is that they can help us understand how things should work, but it is virtually impossible for them to exist in the real world. It is similar to a perfect competition model, some markets might be similar, but it will never exist in reality.