The Consequences of Debt Irrelevance

If the financing decision is irrelevant, as proposed by Miller and Modigliani, corporate financial analysis is simplified in a number of ways. The cost of capital, which is the weighted average of the cost of debt and the cost of equity, is unaffected by changes in the proportions of debt and equity. This might seem unreasonable, especially since the cost of debt is much lower than the cost of equity. In the Miller-Modigliani world, however, any benefits incurred by substituting cheaper debt for more expensive equity are offset by increases in both their costs, as shown in Figure 7.9.

Figure 7.9: Cost of Capital in the MM World

Figure 7.9: Cost of Capital in the MM World

Debt Ratio

The value of the firm is also unaffected by the amount of leverage it has. Thus, if the firm is valued as an all-equity entity, its value will remain unchanged if it is valued with any other debt ratio. (This actually follows from the implication that the cost of capital is unaffected by changes in leverage and from the assumption that the operating cash flows are determined by investment decisions rather than financing decisions.)

Finally, the investment decision can be made independently of the financing decision. In other words, if a project is a bad project when evaluated as an all-equity project, it will remain so using any other financing mix.

Emergency Quick Cash

Emergency Quick Cash

At least once in every person’s life comes a time when the need is great and the resources are few. It can be hard enough to make ends meet on a decent wage, but, when the times get tough and the money just is not there to meet the need, a person can easily despair.

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