Basic Propositions

There are three basic propositions of the MM Approach:

I. The overall cost of capital (ko) and the value of the firm (V) are independent of its capital structure. The ko and V are constant for all degrees of leverage. The total value is given by capitalizing the expected stream of operating earnings at a discount rate appropriate for its risk class.

II. The second proposition of the MM Approach is that the k, is equal to the capitalization rate of a pure equity stream plus a premium for financial risk equal to the difference between the pure equity-capitalization rate (k) and kr times the ratio of debt to equity. In other words, ke increases in a manner to offset exactly the use of a less expensive source of funds represented by debt.

III. The cut-off rate for investment purposes is completely independent of the way in which an investment is financed.

We are Interested mainly in exploring the relationship between leverage and valuation. Our focus, therefore, is on proposition (1).

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