What are the MM Propositions I and II under perfect capital markets?

Miller and Modigliani theory mentions two propositions. Proposition I states that the market value of any firm is independent of the amount of debt or equity in capital structure. Proposition II states that the cost of equity is directly related and incremental to the percentage of debt in capital structure.

What is MM Proposition II?

The second proposition of the M&M Theorem states that the company’s cost of equity. An increase in leverage level induces higher default probability to a company. Therefore, investors tend to demand a higher cost of equity (return) to be compensated for the additional risk.

What is MM’s Proposition 2 quizlet?

What is MM’s Proposition 2? The expected rate of return on the common stock of a levered firm increases in proportion to the debt-equity ratio (D/E), expressed in market values; the rate of increase depends on the spread between rA and rD.

Why is WACC constant under MM?

As a company gears up, the decrease in the WACC caused by having a greater amount of cheaper debt is exactly offset by the increase in the WACC caused by the increase in the cost of equity due to financial risk. The WACC remains constant at all levels of gearing thus the market value of the company is also constant.

Why is MM theory important?

The Modigliani-Miller theorem states that a company’s capital structure is not a factor in its value. Market value is determined by the present value of future earnings, the theorem states. The theorem has been highly influential since it was introduced in the 1950s.

Why does Modigliani and Miller’s Proposition I have to be corrected when there are corporate taxes?

The reason that MM Proposition I does not hold in the presence of corporate taxation is because: Levered firms pay less taxes compared with identical unlevered firms. MM Proposition 1 with taxes is based on the concept that: The value of the firm increases as total debt increases because of the interest tax shield.

How does the Modigliani-Miller Proposition I theory work?

The Modigliani-Miller Proposition I Theory (MM I) states that under a certain market price process, in the absence of taxes, no transaction costs, no asymmetric information and in an perfect market, the cost of capital and the value of the firm are not affected by the changed in capital structure.

What is the cost of equity in Modigliani Miller theory?

The Modigliani-Miller Proposition II Theory (MM II) defines cost of equity is a linear function of the firm’s debt/equity-ratio.

What was the Modigliani and Miller theorem made up of?

The Modigliani and Miller explained the theorem was originally proven under the assumption of no taxes. It is made up of two propositions that are (i) the overall cost of capital and the value of the firm are independent of the capital structure.

What is the revised capital structure of the mm Proposition II?

The revised capital structure of the MM Proposition II, pointed out that the existence of tax shield in a perfect capital market conditions cannot be reached, in an imperfect financial market, the capital structure changes will affect the company’s value.