Damodaran on Valuation

6.4. CAPITAL STRUCTURE AND FIRM VALUE

Both the cost of capital approach and the APV approach make the value of a firm a function of its financial leverage. Implicitly, we are assuming that the value of a firm is determined not just by the investments it makes but also by the mix of debt and equity that it uses to fund these investments. While this may seem logical, there is substantial debate in corporate finance on whether the financial leverage of a firm should affect its value. In this chapter, we will begin with a quick review of both sides of the capital structure argument and then consider practical ways of analyzing the effect of capital structure on value.

6.4.1. Should Capital Structure Affect Value?

The opening salvo in this debate was fired by Merton Miller and Franco Modigliani in their seminal paper published in 1958,^[] where they showed that in a world without taxes, default risk, and agency problems, the value of a firm is determined by the quality of its investments and not by the mix of debt and equity used to fund them. The argument they used was simple and powerful. They conceded that debt is cheaper than equity but noted that borrowing money makes equity earnings more volatile and riskier. The resulting increase in the cost of equity exactly offsets any cost savings that will be generated by substituting debt for equity, thus keeping cost of capital constant.

^[] F. Modigliani and M. Miller, "The Cost of Capital, Corporation Finance and the Theory of Investment," ...