How corporations choose to finance their investments might have a direct impact on firm value. Firm value is determined by discounting all future cash flows with the weighted average cost of capital, which makes it important to understand whether the weighted average cost of capital can be minimized by selecting an optimal capital structure (i.e. mix of debt and equity financing). To facilitate the discussion consider first the characteristics of debt and equity.

8.1. Debt characteristics

Debt has the unique feature of allowing the borrowers to walk away from their obligation to pay, in exchange for the assets of the company. "Default risk" is the term used to describe the likelihood that a firm will walk away from its obligation, either voluntarily or involuntarily. "Bond ratings" are issued on debt instruments to help investors assess the default risk of a firm.

Debt maturity

- Short-term debt is due in less than one year

- Long-term debt is due in more than one year

Debt can take many forms:

• Bank overdraft

• Commercial papers

• Mortgage loans

• Bank loans

• Subordinated convertible securities

• Leases

• Convertible bond

8.2. Equity characteristics

Ordinary shareholders:

- Are the owners of the business

- Have limited liability

- Hold an equity interest or residual claim on cash flows

- Have voting rights

Preferred shareholders:

- Shares that take priority over ordinary shares in regards to dividends

- Right to specified dividends

- Have characteristics of both debt (fixed dividend) and equity (no final repayment date)

- Have no voting privileges

8.3. Debt policy

The firm's debt policy is the firm's choice of mix of debt and equity financing, which is referred to as the firm's capital structure. The prior section highlighted that this choice is not just a simple choice between to financing sources: debt or equity. There exists several forms of debt (accounts payable, bank debt, commercial paper, corporate bonds, etc.) and two forms of equity (common and preferred), not to mention hybrids. However, for simplicity capital structure theory deals with which combination of the two overall sources of financing that maximizes firm value.

8.3.1. Does the firm's debt policy affect firm value?

The objective of the firm is to maximize shareholder value. A central question regarding the firm's capital structure choice is therefore whether the debt policy changes firm value?

The starting point for any discussion of debt policy is the influential work by Miller and Modigliani (MM), which states the firm's debt policy is irrelevant in perfect capital markets. In a perfect capital market no market imperfections exists, thus, alternative capital structure theories take into account the impact of imperfections such as taxes, cost of bankruptcy and financial distress, transaction costs, asymmetric information and agency problems.

8.3.2. Debt policy in a perfect capital market

The intuition behind Miller and Modigliani's famous proposition I is that in the absence of market imperfections it makes no difference whether the firm borrows or individual shareholders borrow. In that case the market value of a company does not depend on its capital structure.

To assist their argument Miller and Modigliani provides the following example:

Consider two firms, firm U and firm L, that generate the same cash flow

- Firm U is all equity financed (i.e. firm U is unlevered)

- Firm L is financed by a mix of debt and equity (i.e. firm L is levered)

Letting D and E denote debt and equity, respectively, total value V is comprised by

- VU = EU for the unlevered Firm U

- VL = DL + EL for the levered Firm L

Then, consider buying 1 percent of either firm U or 1 percent of L. Since Firm U is wholly equity financed the investment of 1% of the value of U would return 1% of the profits. However, as Firm L is financed by a mix of debt and equity, buying 1 percent of Firm L is equivalent to buying 1% of the debt and 1% of the equity. The investment in debt returns 1% of the interest payment, whereas the 1% investment in equity returns 1% of the profits after interest. The investment and returns are summarized in the following table.

Thus, investing 1% in the unlevered Firm U returns 1% of the profits. Similarly investing 1% in the levered firm L also yields 1% of the profits. Since we assumed that the two firms generate the same cash flow it follows that profits are identical, which implies that the value of Firm U must be equal to the value of Firm L. In summary, firm value is independent of the debt policy.

Consider an alternative investment strategy where we consider investing only in 1 percent of L's equity. Alternatively, we could have borrowed 1% of firm L's debt, DL, in the bank and purchased 1 percent of Firm U.

The investment in 1% of Firm L's equity yields 1% of the profits after interest payment in return. Similarly, borrowing 1% of L's debt requires payment of 1% of the interest, whereas investing in 1% of U yields 1% of the profits.

It follows from the comparison that both investments return 1% of the profits after interest payment. Again, as the profits are assumed to be identical, the value of the two investments must be equal. Setting the value of investing 1% in Firm L's equity equal to the value of borrowing 1% of L's debt and investing in 1% of U's equity, yields that the value of Firm U and L must be equal

The insight from the two examples above can be summarized by MM's proposition I:

Miller and Modigliani's Proposition I

In a perfect capital market firm value is independent of the capital structure

MM-theory demonstrates that if capitals markets are doing their job firms cannot increase value by changing their capital structure. In addition, one implication of MM-theory is that expected return on assets is independent of the debt policy.

The expected return on assets is a weighted average of the required rate of return on debt and equity,

Solving for expected return on equity, rE, yields:

This is known as MM's proposition II.

Miller and Modigliani's Proposition II

In a perfect capital market the expected rate of return on equity is increasing in the debt-equity ratio.

At first glance MM's proposition II seems to be inconsistent with MM's proposition I, which states that financial leverage has no effect on shareholder value. However, MM's proposition II is fully consistent with their proposition I as any increase in expected return is exactly offset by an increase in financial risk borne by shareholders.

The financial risk is increasing in the debt-equity ratio, as the percentage spreds in returns to shareholders are amplified : IC operating; income falls the percentage decline in the return is larger for levered equity since the interest payment is a fixed cost the firm has to pay independent of the operating income.

Finally, notice that even though the expected return on equity is increasing with the financial leverage, the expected return on assets remains constant in a perfect capital market. Intuitively, this occurs because when the debt-equity ratio increases the relatively expensive equity is being swapped with the cheaper debt. Mathematically the two effects (increasing expected return on equity and the substitution of empty with debt) exactly off set each other.

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