Chapter 16: Does Capital Structure Matter?

MM Proposition 1 is presented, asserting that in perfect, frictionless financial markets, the total value of a firm is determined solely by its real assets and growth opportunities, rendering capital structure irrelevant. This concept represents an application of the law of the conservation of value, implying that how a firm slices its cash flows into debt and equity does not alter the size of the total pie. The text explains how investors can use "homemade leverage"—borrowing or lending on their own account—to replicate or undo the effects of corporate leverage, thereby enforcing the law of one price. The chapter subsequently explores MM Proposition 2, which addresses the relationship between financial leverage and expected returns. It demonstrates that while debt may appear cheaper, increasing leverage increases the financial risk borne by shareholders, causing the expected return on equity (the cost of equity) to rise in direct proportion to the debt-equity ratio. Consequently, in a no-tax environment, the overall company cost of capital (the return on assets) remains constant regardless of the borrowing level. This relationship is further analyzed through the lens of market risk, showing how the equity beta increases with leverage while the asset beta remains unchanged, reflecting the underlying business risk. Practical considerations are also addressed, warning financial managers against "hidden leverage" found in off-balance-sheet obligations like long-term leases and pension liabilities, which must be treated as debt equivalents when calculating net present value. The chapter briefly touches upon unsatisfied clienteles and market imperfections but suggests these rarely provide lasting value due to supply responses. Finally, the analysis pivots to the real-world impact of corporate taxes, modifying the MM framework to show how the tax deductibility of interest payments creates a tax shield. This leads to the calculation of the after-tax weighted average cost of capital (WACC), which, unlike the opportunity cost of capital, declines as the debt ratio increases because the government effectively subsidizes interest payments.