Understanding M&M's story
(some heuristic proofs)
Proof 1:
Consider a firm with investment projects that will produce the following future cash flows with certainty (assuming risk-free rate = 5%):
|
Year |
||||
|
0 |
1 |
2 |
3 |
|
|
Cash Flow |
$100 |
$100 |
$100 |
|
How much is the firm worth if it is 100% equity financed?
|
Year |
||||
|
0 |
1 |
2 |
3 |
|
|
Equity receives |
$100 |
$100 |
$100 |
|
|
PV(Equity) |
$272.32 |
|||
|
PV(Firm) |
$272.32 |
|||
How much is the firm worth if it has debt in its capital structure which obligates it to make a payment of $100 at the end of year 3?
|
Year |
||||
|
0 |
1 |
2 |
3 |
|
|
Debt receives |
$100 |
|||
|
Equity receives |
$100 |
$100 |
||
|
PV(Debt) |
$86.38 |
|||
|
PV(Equity) |
$185.94 |
|||
|
PV(Firm) |
$272.32 |
|||
The value of the firm will remain the same, regardless of how we divide up the claims on the future cash flows.