Leverage Strategy

The beauty of the Modigliani-Miller (M&M) Theorem on the Irrelevance of Capital Structure lies in its ability to clarify investment and financial decisions.

The theorem consists of two propositions:

• Proposition I relies on the fundamental law of the conservation of value, stating: the value of an organization is determined by the real assets on the left side of the balance sheet, regardless of the source of financing.
• Proposition II states that the expected return on equity increases proportionally with leverage. The higher the proportion of debt in external financing, the higher the risk, and consequently, the higher the expected return on equity. (Risk here refers to the range of possible deviations from the projected profit).

rE = rA + (rA − rD)*D/E

From the second proposition, it follows that the discount rate used in valuing an organization is not dependent on leverage – the Weighted Average Cost of Capital (WACC) remains stable, which greatly aids in determining the fair price of the organization.

The graph below also shows that the cost of debt does not initially increase because, with very low leverage, the debt is in the “Risk-Free” zone (referring to systemic, not specific risk).

P.S.
The M&M theorem is related to the Capital Asset Pricing Model (CAPM) in that the beta of assets is a weighted average of the beta of debt and the beta of equity.

βA = βportfolio = βD * (D/V ) + βE *(E/V).

P.P.S.
In your opinion, does an optimal level of leverage exist?

Source:

Principles of Corporate Finance – by F. Allen, R. A. Brealey, & S. Myers