What is the MM Theory?
After learning about the cost of capital and WACC, the next topic is MM Theory.
When learning about WACC,
👉 we learned that increasing borrowing lowers the cost of capital
.
However, the MM theory is a theory that increasing borrowing does not change the firm value.
1. The Starting Point of MM Theory
What the MM theory deals with is
👉 the issue of what proportion of debt and equity a company uses
.
This is called "capital structure".
2. Proposition I (Without Corporate Tax)
First, let's start with the most famous conclusion.
Even if the capital structure is changed, the firm value does not change
The claim of Proposition I is that in a world without corporate tax,
👉 even if the capital structure is changed, the firm value does not change
is the first proposition of the MM theory.
In other words,
even with 100% debt
even with 100% equity
or even with half of each
the firm value is the same.
Why can we say that?
The reason is this:
firm value is determined by the "cash flow generated by the business"
and
is not determined by how it is divided (debt or equity)
.
In short,
the left side of the company (assets) creates value
the right side (liabilities/equity) is merely a way of dividing it
is how it is organized.
3. Proposition II (Without Corporate Tax)
If borrowing is increased, the cost of equity capital rises
Next is the second proposition.
👉 It states that as borrowing increases, the cost of equity rises.
Why?
The reason is an increase in risk.
When borrowing increases,
interest payments become fixed.
the shareholders' portion becomes unstable.
In other words, shareholder risk increases and as a result,
👉 shareholders demand a higher expected rate of return.
This is the reason for the rise in the cost of equity.
So what happens?
When borrowing increases,
the cost of debt is low,
but the cost of equity rises.
As a result, "WACC remains unchanged."
This is consistent with Proposition I.
4. When corporate tax exists
Tax shield effect of interest
In the real world, interest payments are tax-deductible.
In other words,
👉 borrowing has a tax-saving effect.
Proposition I (with corporate tax)
When corporate tax exists, "the more a company borrows, the higher its corporate value becomes."
This is because "a tax shield is created."
Corporate value formula (with corporate tax)
レバード企業価値 = 無借金企業価値 + 節税効果の現在価値This becomes the formula. In other words,
👉 debt boosts corporate value.
This is the conclusion.
5. Should debt be increased infinitely?
Theoretically, that is correct. But reality is different.
In reality, there are bankruptcy costs.
When borrowing becomes excessive,
the risk of bankruptcy increases
credit anxiety arises
trading conditions deteriorate
In other words, "financial distress costs" occur.
Optimal Capital Structure in Reality
Real-world companies determine their capital structure by balancing "tax shield benefits" and "financial distress costs". This is the "
Trade-off Theory".
6. Connection to DCF and WACC
The MM theory is actually a theory that deepens the understanding of WACC.
No corporate tax → WACC is constant
With corporate tax → Increased borrowing lowers WACC 👉 Corporate value increases
Therefore, the MM theory provides a theoretical answer to the question, "Does capital structure affect corporate value?".
✅ Summary for myself
Without corporate tax, capital structure does not affect corporate value
As borrowing increases, the cost of equity increases
With corporate tax, borrowing increases corporate value
The reason is the tax-saving effect of interest
In reality, the balance with bankruptcy costs is important