Question

An entrepreneur is offered an investment in his company in return for equity. He refuses, and prefers to take a loan, since by taking equity he will be losing the upside. Is this aregument valid in a M-M world (proposition 1). If so, please explain. If not, what friction can justify this type of argument?

Answer 1

The M-M theorem states that  market value of a company is calculated as the present value of its future earnings and the underlying assets of the company. It can thus be concluded that the market value of a company is independent of its capital structure, or to be precise of its debt equity ratio. The theorem argues that, it is irrelevant whether a company finances its growth by borrowing, by issuing stock shares, or by reinvesting its profits based on certain assumptions.

So, in M-M world, whether he takes loan or opt for equity it will be irrelevant and thus his argument of losing the upside doesnot hold valid.

His argument will be valid when taxes and finance costs are considered. The difference between a levered and unlevered firm is mostly because of tax savings on debt and debt being cheaper source.