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Hello Mr Moffat,
I have two question regarding M&M assumption, would you please explain why in M&M theory :
1 – We assume that both individuals (which I think we call it homemade borrowing?) and corporations borrow at the SAME rate? What is the concept behind it? Why does homemade borrowing relates to this subject at all?!! Why same rate?!
2 – We ignore personal tax and not corporation tax.
I feel both of these two assumptions should somehow be used in the proof of their theory. But because I don’t know its proof (as it is no needed for the exam), so I just want an overall reason for these 2 assumptions to learn them, not just memorise them!
Thank you very much.
Honestly, I also did some search on the internet about the first questions ( why borrow at the same rate).
What I understood was that it seems they use something called “arbitrage process” for the proof of their theory and we assume that for example we sell 10% of an geared company, then borrow some money (which I really don’t get why we have to suppose we borrow some money) and then we use total money we have to buy shares of an ungeared company. and at the end it was shown that we are making profit after these transaction, so this could lead to adjust the price of two firms after a while and making their value equal! Full of ambiguity 🙁
1. The first paper that M&M wrote ignored both corporate and personal tax. They then went further and included corporate tax (but still assumed no personal tax). I explain their conclusions in both of these in my free lectures.
They did then go on and include personal tax (personal tax reduces the benefit of debt). However this is excluded from the syllabus and so for the exam anything we do using M&M assumes that there is no personal tax.2. The ‘proof’ of M&M used to be examined, but was removed from the syllabus many years ago. So I am not going to work through the entire proof here. However basically it looks at a shareholder owning shares in an ungeared company and switching to shares in a geared company – the market values change so that they get the same income either way. However the problem is that you can’t simply compare dividend income from a geared company with dividend income from an ungeared company because the dividends from the geared company are more risky (due to the payment of interest on borrowing before the dividends are paid – as illustrated in my Paper FM lectures). So to make them comparable, the ‘proof’ has the shareholder in the ungeared company borrow money so that their net income is also after payment of interest. There is nothing ambiguous, but the M&M ‘proof’ does assume that there is no difference between the company paying interest and the individual shareholder paying interest.
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