Capital Structure Irrelevance – MM Prop I and II with Detailed Examples

This video covers the following learning objectives:

• Define capital structure and explain how firms use debt and equity to finance operations.

• Understand Modigliani and Miller Proposition I, which states that in perfect markets, a firm’s value is independent of its capital structure.

• Explain the concept of homemade leverage, where investors can adjust their personal risk exposure by borrowing or lending, replicating desired leverage levels.

• Apply MM Proposition I using numerical examples, demonstrating how firm value remains constant under different capital structures.

• Understand Modigliani and Miller Proposition II, which shows how the cost of equity increases with financial leverage due to greater shareholder risk.

• Calculate the cost of equity using MM Proposition II formula, incorporating leverage, unleveraged cost of equity, and cost of debt.

• Demonstrate WACC stability under MM’s perfect market assumptions, using Excel-based calculations.

• Identify real-world factors that modify MM theory, including taxes, bankruptcy risk, and imperfect information.

• Relate MM Propositions to major financial certifications, including:

  • CFA Level 1: Capital structure, risk-return, WACC

  • CSC: Corporate financing and firm value impacts

  • FRM: Leverage and risk management in practice

  • CFP: Financing decisions in business valuation