MM theory assumes that the cost of debt capital is risk-free interest rate, and debt-free equity capital is measured by the variance of earnings before interest and tax, and thinks that this is a perfect market, that is, the variance of earnings before interest and tax of the whole society should be the smallest.
The interest rate measured by this variance is the risk-free interest rate, so the cost of debt capital is the smallest, so as far as the cost of equity capital of a company is concerned, it is at least greater than or equal to the cost of debt capital.
Extended data:
There are two main types of MM theory: MM model without corporate tax and MM model with corporate tax.
MM model without corporate tax
MM theory points out that the total risk of all securities holders of a company will not change because of the change of capital structure. Therefore, regardless of the company's financing portfolio, the total value of the company must be the same.
The existence of arbitrage in capital market is an important support for this hypothesis. Arbitrage avoids the different prices of perfect substitutes in the same market. Here, complete substitution refers to two or more companies with the same risk but different capital structures. MM theory holds that the total value of such companies should be equal.
You can use formulas to define the company value excluding corporate tax. The value of a company can be determined by converting its operating net profit into capital according to an appropriate capitalization ratio. The formula is:
Vu = Wu =EBIT/K=EBIT/Ku
Where VL is the value of a company with leverage and Vu is the value of a company without leverage; K= Ku is the appropriate capitalization ratio, that is, the discount rate; EBIT is net profit before interest and tax.
According to MM theory without corporate tax, corporate value has nothing to do with corporate capital structure. In other words, whether the company has liabilities or not, the weighted average cost of capital of the company is unchanged.
MM model with corporate tax
MM theory holds that when there is corporate tax, the advantage of borrowing is that debt interest payment can be used to offset the tax, so financial leverage reduces the weighted average cost of capital after tax.
The present value of tax avoidance income can be expressed by the following formula:
Present value of tax avoidance income = TC * R * B/R = TC * B
Where: tc is the corporate tax rate; R is the debt interest rate; B is the market value of debt.
Therefore, the more debt the company has, the greater the tax avoidance income and the greater the company value. Therefore, after adding corporate tax to the original MM model, it can be concluded that the existence of tax is an important manifestation of the imperfection of the capital market. When the capital market is imperfect, the change of capital structure will affect the value of the company.
In other words, the company's value and capital cost change with the change of capital structure. The value of leveraged companies will exceed that of non-leveraged companies (that is, the value of indebted companies will exceed that of non-indebted companies). The more debt, the greater the difference. When the debt reaches 65,438+000%, the company's value will be the largest.
Baidu encyclopedia -MM theory