APPENDIXES

Structured Finance and Insurance: The Art of Managing
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By Christopher L. Culp
Copyright 2006 by Christopher L. Culp

APPENDIX A
Capital Structure Irrelevance

T he 1958 paper by Franco Modigliani and Merton Miller (M&M), The

Cost of Capital, Corporation Finance, and the Theory of Investment, is
almost universally regarded as having created the modern theory of corpo-
rate finance. As Ross (1988) says, If the view of the progress of science
that interprets it as one of changing paradigms has merit, then surely the
work of Miller and Modigliani provides a laboratory example of a vio-
lently shifted paradigm (p. 127).
Prior to M&M, the conventional belief was that because debt was
cheaper than equity, a firms value should rise with increased leverage, at
least up to some threshold level of debt beyond which a company would
have difficulty servicing.1 Consequently, the average cost of capital for a
firm was thought to fall for increases in debt, as long as the firm avoided
truly excessive leverage. M&M showed that this conventional wisdom was
wrong, at least under certain assumptions.
The four assumptions under which the three M&M irrelevance
propositions hold are:2

1. Perfect capital markets. Capital markets are perfect in the sense of no

taxes, no transaction costs, no institutional frictions (e.g., short selling
restrictions on securities), no costs of bankruptcy or financial distress,
and no unexploited riskless arbitrage opportunities.
2. Symmetric information. All investors and managers have the same
information about the quality of a firms investments and have iden-
tical (as well as correct) perceptions concerning the impact of
new information on the prices of all financial instruments, including
securities.
3. Equal access. Firms and individuals can issue the same securities in the
capital markets on exactly the same terms.3
4. Given investment strategies. Investment decisions by firms are taken as
a given.

779
780 APPENDIX A

When these assumptions hold, M&M demonstrated that a firms value is

driven solely by its investment decisions and that the purely financial deci-
sions made by the firm are irrelevant to the value of the firm. Such deci-
sions will, of course, generally affect the relative welfare of the firms
different security holders, but they will not affect the total wealth of all in-
vestors combined.
Many question the need to study the M&M irrelevance propositions,
arguing that the assumptions underlying the propositions are so unrealistic
as to render the M&M world irrelevant in the real world. For some, per-
haps that is true. But for those uninitiated in the modern theory of corpo-
ration finance, the M&M world provides a very useful starting point. The
M&M propositions essentially give us a laboratory control of corporate
financing decisions, or a base case against which alternatives that do in-
volve deviations from the M&M world can be compared. As Miller aptly
put it, [S]howing what doesnt matter [in corporate finance] can also
show, by implication, what does (Miller 1988).
Nevertheless, this discussion is relegated here to an appendix. The
chapters in the main body of our textespecially in Part Oneassume
that readers are thoroughly familiar with the M&M assumptions and what
they imply. If you are, then feel free to skip this appendix. But if not, this
short summary of one of the fundamental works of academic finance the-
ory should provide an adequate introduction.

PROPOSITION I: CAPITAL STRUCTURE

The most important implication of the M&M assumptions is that the

value of a firm and its cost of capital depend entirely on the real assets that
the firm owns, and the firms financial capital structure cannot ever impact
the market value of those real assets. We saw in Chapter 1 when we looked
at the economic balance sheet of the firm that the market value of a firms
assets is always equal to the aggregate value of its financial capital, and
that will continue to be true. What we essentially want to explore now is
why the value of a package of real assets does not depend on the firm that
owns them.
M&M referred to capital structure irrelevance as their Proposition I,
which in their original paper stated that the market value of any firm is
independent of its capital structure and is given by capitalizing its expected
return at the rate Pk appropriate to its [risk] class (M&M 1958, p. 268).
So, the value of an unleveraged firm should be the same as the value of a
leveraged firm holding the same assets.
To prove Proposition I, M&M argued that investors need not invest in
Capital Structure Irrelevance 781

leveraged firms to take whatever advantage leverage itself might have. In-
stead, investors could invest in unleveraged firms and borrow on their own
account to manufacture homemade leverage. If the assets held by the
leveraged and unleveraged firm are identical, then both strategies will yield
the same payoff as long as the M&M assumptions hold. To preclude the
existence of riskless arbitrage opportunities, the costs of the strategies thus
must be the same, and, hence, the values of the leveraged and unleveraged
firms must be equal.4
M&M also stated their Proposition I in terms of the firms cost of rais-
ing capital by issuing debt and equity securities: The average cost of capi-
tal to any firm is completely independent of its capital structure (M&M
1958, p. 268).
M&M showed that the conventional wisdom that the average cost of
capital for a firm would fall for increases in debt was wrong, at least under
their four assumptions. Instead, the firms average cost of capital depends
entirely on the risk of the real assets owned by the firm and the expected
return on those assets. The risk of those real assets, moreover, does not de-
pend on the firm that owns themat least not in an M&M world.
When M&M were writing, the modern theory of finance was not yet
well developed. Terms like systematic and idiosyncratic were not to be
found in the tools of the trade that M&M had to work with.5 Today, we
can be much more general in stating Proposition I and say that the firms
average cost of capital depends only on the systematic risks facing the firm.
The reason? In an M&M world of perfect markets, symmetric informa-
tion, and equal access, investors can eliminate all firm-specific or idiosyn-
cratic risks through portfolio diversification decisions. So, the firms
average cost of capital is the capitalization rate for the firms assets, or the
expected return on the assets the firm owns.

PROPOSITION II: WEIGHTED AVERAGE

COST OF CAPITAL

M&M Proposition I told us that the value of the firm did not depend on its
leverage. In Proposition II, M&M showed that the expected return on a
share of stock increases as a firms leverage ratio increases, and this in-
creased expected return is exactly offset by increasing risk that causes share
holders to demand a higher expected return on their equity capital.
M&M argued that [a] number of writers have stated close equiva-
lents to our Proposition I although by appealing to intuition rather than by
attempting a proof. . . . Proposition II, however, so far as we have been
able to discover is new (M&M 1958, p. 271). Proposition II holds that
782 APPENDIX A

the expected yield of a share of stock is equal to the appropriate capital-

ization rate for a pure equity stream in that [risk] class, plus a premium re-
lated to financial risk equal to the debt-to-equity ratio times the spread
between [the capitalization rate for the pure equity stream] and [the inter-
est rate on the firms debt]. Formally, Proposition II can be written as

Dj (t)
E(RjS ) = E(R A ) + [ E(R A ) RD
j ] (A.1)
S j (t)

where RDj and RSj represent the return on firm js debt and equity (respec-
tively) from time t.6
Equation (A.1) is often rewritten to express the firms weighted aver-
age cost of capital (WACC):

S j (t) Dj (t)
E(RWACC
j )= E(RjS ) + RD A
j = E(R ) (A.2)
S j (t) + Dj (t) S j (t) + Dj (t)

An inspection of equation (A.2) immediately confirms what we saw in

Proposition Ithat the firms WACC is equal to the expected return on
the assets held by the firm (appropriately adjusted for systematic risk) and
does not depend on the relative proportions of debt and equity issued by
the firm.
Note in particular in (A.2) that the WACC of firm j carries the sub-
script j, whereas the expected return on the assets owned by firm j does
not. This is an immediate implication of Proposition Ithat the expected
return on the assets owned by the firm does not depend on the particular
firm that owns them.
We have assumed for simplicity that the firms debt has a constant in-
terest rate and is riskless. Exhibit A.1 may provide some insight into the in-
tuition underlying M&M Proposition II when we allow for the possibility
that debt holders may not receive a full or even partial repayment. The flat
heavy black line is the expected return on the firms assets, which does not
depend on the firms capital structureProposition I. This is also the firms
WACC. If the firm has no debt, the expected return on the firms equityin
that case also the firms WACCis equal to the expected return on the as-
sets held by the firm.
Assume that the debt issued by the firm becomes risky at leverage ratio
D*/(S + D) in Exhibit A.1. For levels of debt below that point, bondholders
have a constant expected return equal to the stated interest rate on the
debt. But once leverage rises to the point that debt holders are exposed to
Capital Structure Irrelevance 783

Returns

S
E(Rj )

A WACC
E(R ) E(Rj )
D
E(Rj )

D*/(S + D) D/(S + D) = Leverage

EXHIBIT A.1 The Invariance of WACC to Firm-Specific Risk

the risk of default, bondholders will demand a higher expected return. This
increase in expected returns on debt, moreover, occurs at an increasing
rate. As the firm builds up more and more leverage, bondholders bear
more and more relative risk of the firms assets.
Now look at the expected return on equity in Exhibit A.1. For low lev-
els of leverage at which the firms debt is default risk-free, the expected re-
turn on equity increases proportionately with the firms leverage, just as
Proposition II tells us. At leverage ratio D*/(S + D), the increase in ex-
pected returns demanded by stockholders begins to level off. Because debt
holders now bear some of the asset risk, stockholders no longer require the
same compensation for increased leverage as they did when debt was de-
fault risk-free and equity was bearing all the asset risk.
Importantly, notice how leverage affects the two classes of securities in
the context of Proposition II, which tells us that the WACC of the firm is
invariant to leverage. As long as debt is default risk-free, all of the in-
creased risk of leverage is borne by equity holders. But the WACC does not
change because the increased risk to equity is directly proportional to the
change in the values of the firms outstanding securities. When debt be-
comes risky, the premium demanded by bondholders is then just offset by a
784 APPENDIX A

lower premium demanded by stockholders. In other words, the increased

return demanded by debt is offset by a corresponding decrease in the lever-
age risk premium demanded by equity, again leaving the firms WACC con-
stant and equal to the expected return on the firms assets.

PROPOSITION III: SOURCES OF FINANCE

FOR NEW INVESTMENTS
With perfect capital markets, symmetric information, equal access, and
given investment strategies, the value to a firm of undertaking a new in-
vestment in real capital, a new growth opportunity, or a new project does
not depend on how the investment or project is financed. This is known as
M&M Proposition III: The cut-off point for investment . . . will be com-
pletely unaffected by the type of security used to finance the investment
(M&M 1958, p. 288).
Our model follows closely the original work of M&M (1958), modi-
fied primarily to adopt the notation used throughout this book. Specifi-
cally, consider a capital investment project that generates a single cash flow
at time t + 1 in the amount X(t + 1). This cash flow is realized only if the
firm makes a one-time investment of I(t) at time t. The return on this in-
vestment is defined as

E[ X(t + 1)] I(t)

(t) =
I(t)
We assume only a single cash distribution and a single investment cost
purely to reap the gains from working with a two-period model. In fact,
this is still a completely general representation. If future expenditures are
required to maintain the project, for example, I(t) is then just the present
value of those expenditures expressed in time t dollars. Similarly, any cash
distributions beyond time t + 1 would just be reflected in X(t + 1) on a dis-
counted expected present value basis. So, we get to work here with such a
simple model with absolutely no loss of generality.
M&M Proposition III says that the hurdle rate for all capital invest-
ments is the expected return on the assets of the firm, or the firms WACC.
Specifically, a firm should undertake a capital investment project if

(t) E(RA)

This criterion is not affected by the means used by the firm to finance the
investment in an M&M world.
Capital Structure Irrelevance 785

Suppose for simplicity that the firm has no growth opportunities and
has only ssets in place. The value of the firm prior to undertaking the new
investment project is then:

E[ X(t + 1)]
V (t) = (A.3)
1 + E(R A )

where X(t + 1) denotes the net cash flows on the firms existing assets in
place before the new project. Again we are assuming a two-period model,
so that any future net cash flows are subsumed into X(t + 1) on a dis-
counted present value basis. So, the value of the firm at time t is equal to
the expected net cash flow on the firms assets in place at time t + 1 dis-
counted at the expected return on those assets.

Project Financed with a New Debt Issue

Suppose first that the firm considers the new project financed exclusively
with a new debt issue. Prior to undertaking the project, the market value of
the firms common stock is

S(t) = V(t) D(t) (A.4)

If the firm borrows I(t) to finance a new project with a return (t), the
value of the firm next period will be

E[ X(t + 1)] + I(t)[1 + (t)] I(t)[1 + (t)]

V (t + 1) = A
V (t) + (A.5)
1 + E(R ) 1 + E(R A )

If the new project is accepted, the time t + 1 value of the firms stock
will be

I(t)[1 + (t)]
S(t + 1) = V (t + 1) [D(t) + I(t)] = V (t) + [D(t) + I(t)] (A.6)
1 + E(R A )

Using equation (A.4), equation (A.6) can be re-written as

I(t)[1 + (t)]
S(t + 1) = S(t) + I(t) (A.7)
1 + E(R A )
786 APPENDIX A

From equation (A.7), we can see that the project will raise the value of the
firms stock only if

(t) > E(RA)

and will reduce the value of the firms equity otherwise. Because the debt
issued to finance the project is issued at a fair market price, the value of the
firm will rise if the value of the stock rises and conversely fall if the value of
the stock falls.

Project Financed with Retained Earnings

Now suppose the firms assets in place have generated surplus cash in an
amount exactly equal to I(t) as of time t. The firm can either pay a dividend
to stockholders or use the cash to finance the new project.
If the firm distributes the cash to stockholders at time t, we can write
the time t shareholder wealth as

E[ X(t + 1)]
W S (t) = S(t) + I(t) = D(t) + I(t) (A.8)
1 + E(R A )

If instead the firm retains the cash I(t) and uses that cash to finance the new
project, the firms shareholder wealth at time t + 1 is then

E[ X(t + j )] + I (t )[1 + (t )] (A.9)

W S (t + 1) = S(t + 1) = D(t )
1 + E(R A )
(A.9)
I (t )[1 + (t )]
= S(t ) +
1 + E(R A )

As in the debt financing case, shareholder wealth increases when the firm
accepts the new project only if

(t) > E(RA)

Project Financed with a New Equity Issue

Finally, suppose the firm raises funds I(t) to fund the new project by issuing
new stock. Suppose further that prior to the project, the firm had N shares
of common stock outstanding with a price per share of s(t) = S(t)/N. At
Capital Structure Irrelevance 787

that price per share, the firm needs to issue M new shares to fund the in-
vestment:

I (t ) (A.10)
M= (A.10)
s(t )

If the firm accepts the project, the total value of the firms equity at
time t + 1 (including the newly issued stock) is now

E[Q(t + j)] + I(t)[1 + (t)] I(t)[1 + (t)] (A.11)

S(t + 1) = D(t) = S(t) +
1 + E(R A ) 1 + E(R A ) (A.11)
I(t)[1 + (t)]
= Ns(t) +
1 + E(R A )

and the new price per share is

S(t + 1) 1 I(t)[1 + (t)]

s(t + 1) = = Ns(t) + (A.12)
N + M N + M 1 + E(R A )

Using equation (A.10), we can simplify equation (A.12) to

(A.13)
1 [(t) E(R A )]
s(t + 1) = s(t) + I(t) (A.13)
N + M 1 + E(R A )

from which we can see once again that the project only makes sense if

(t) > E(RA)