Modigliani–Miller theorem

The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed.^[1] It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani–Miller theorem is also often called the capital structure irrelevance principle.

Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions.

Miller was a professor at the University of Chicago when he was awarded the 1990 Nobel Prize in Economics, along with Harry Markowitz and William Sharpe, for their "work in the theory of financial economics," with Miller specifically cited for "fundamental contributions to the theory of corporate finance."

Historical background

Miller and Modigliani derived the theorem and wrote their groundbreaking article when they were both professors at the Graduate School of Industrial Administration (GSIA) of Carnegie Mellon University. The story goes that Miller and Modigliani were set to teach corporate finance for business students despite the fact that they had no prior experience in corporate finance. When they read the material that existed they found it inconsistent so they sat down together to try to figure it out. The result of this was the article in the American Economic Review and what has later been known as the M&M theorem.

Propositions

The theorem was originally proven under the assumption of no taxes. It is made up of two propositions which can also be extended to a situation with taxes.

Consider two firms which are identical except for their financial structures. The first (Firm U) is unlevered: that is, it is financed by equity only. The other (Firm L) is levered: it is financed partly by equity, and partly by debt. The Modigliani–Miller theorem states that the value of the two firms is the same.

Without taxes

Proposition I: $V_U = V_L \,$ where V_U is the value of an unlevered firm = price of buying a firm composed only of equity, and V_L is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity. Another word for levered is geared, which has the same meaning.^[2]

To see why this should be true, suppose an investor is considering buying one of the two firms U or L. Instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the same amount of money B that firm L does. The eventual returns to either of these investments would be the same. Therefore the price of L must be the same as the price of U minus the money borrowed B, which is the value of L's debt.

This discussion also clarifies the role of some of the theorem's assumptions. We have implicitly assumed that the investor's cost of borrowing money is the same as that of the firm, which need not be true in the presence of asymmetric information, in the absence of efficient markets, or if the investor has a different risk profile to the firm.

'Proposition II:.

Proposition II with risky debt. As leverage (D/E) increases, the WACC (k0) stays constant.

$k_e =k_0+ \frac{D}{E}\left( {k_0 - k_d } \right)$

• k_e is the required rate of return on equity, or cost of equity.
• k₀ is the company unlevered cost of capital (ie assume no leverage).
• k_d is the required rate of return on borrowings, or cost of debt.
• $\frac{D}{E}$ is the debt-to-equity ratio.

A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt. The formula is derived from the theory of weighted average cost of capital (WACC).

These propositions are true assuming the following assumptions:

• no taxes exist,
• no transaction costs exist, and
• individuals and corporations borrow at the same rates.

These results might seem irrelevant (after all, none of the conditions are met in the real world), but the theorem is still taught and studied because it tells something very important. That is, capital structure matters precisely because one or more of these assumptions is violated. It tells where to look for determinants of optimal capital structure and how those factors might affect optimal capital structure.

With taxes

Proposition I:

$V_L =V_U + T_C D\,$

where

• V_L is the value of a levered firm.
• V_U is the value of an unlevered firm.
• T_CD is the tax rate (T_C) x the value of debt (D)
• the term T_CD assumes debt is perpetual

This means that there are advantages for firms to be levered, since corporations can deduct interest payments. Therefore leverage lowers tax payments. Dividend payments are non-deductible.

Proposition II:

$r_E = r_0 + \frac{D}{E}(r_0 - r_D)(1-T_C)$

where

• r_E is the required rate of return on equity, or cost of levered equity = unlevered equity + financing premium.
• r₀ is the company cost of equity capital with no leverage (unlevered cost of equity, or return on assets with D/E = 0).
• r_D is the required rate of return on borrowings, or cost of debt.
• D / E is the debt-to-equity ratio.
• T_c is the tax rate.

The same relationship as earlier described stating that the cost of equity rises with leverage, because the risk to equity rises, still holds. The formula however has implications for the difference with the WACC. Their second attempt on capital structure included taxes has identified that as the level of gearing increases by replacing equity with cheap debt the level of the WACC drops and an optimal capital structure does indeed exist at a point where debt is 100%

The following assumptions are made in the propositions with taxes:

• corporations are taxed at the rate T_C on earnings after interest,
• no transaction costs exist, and
• individuals and corporations borrow at the same rate

Miller and Modigliani published a number of follow-up papers discussing some of these issues.

The theorem was first proposed by F. Modigliani and M. Miller in 1958.

Economic consequences

While it is difficult to determine the exact extent to which the Modigliani–Miller theorem has impacted the capital markets, the argument can be made that it has been used to promote and expand the use of leverage.

When misinterpreted in practice, the theorem can be used to justify near limitless financial leverage while not properly accounting for the increased risk, especially bankruptcy risk, that excessive leverage ratios bring. Since the value of the theorem primarily lies in understanding the violation of the assumptions in practice, rather than the result itself, its application should be focused on understanding the implications that the relaxation of those assumptions bring.

Criticisms

The main problem with the Modigliani and Miller (1958) is that they assume shareholders are the owners of the public corporations. This assumption has been refuted by legal scholars since Berle and Means (1932). Shareholders are neither the owners, residual claimants (i.e. owners of the profit), or the investors as 99.9% are in the secondary market.

The formula's use of EBIT / Cost of Capital to calculate a company's value is extremely limiting. It also uses the weighted average cost of capital formula, which calculates the value based on E + D, where E = the value of equity and D = the value of debt. Modigliani and Miller are equating two different formulas to arrive at a number which maximizes a firm's value. It is inappropriate to say that a firm's value is maximized when these two different formulas cross each other because of their striking differences. The formula essentially says a firm's value is maximized when a company has earnings * the discount rate multiple = book value. Modigliani and Miller equate E + D = EBIT / Cost of Capital. This seems to over-simplify the firm's valuation.

Notes

1. ^ MIT Sloan Lecture Notes, Finance Theory II, Dirk Jenter, 2003
2. ^ Arnold G. (2007)

References

• Brealey, Richard A.; Myers, Stewart C. (2008) [1981]. Principles of Corporate Finance (9th ed.). Boston: McGraw-Hill/Irwin. ISBN 9780073405100. 
• Stewart, G. Bennett (1991). The Quest for Value: The EVA management guide. New York: HarperBusiness. ISBN 0887304184. 
• Modigliani, F.; Miller, M. (1958). "The Cost of Capital, Corporation Finance and the Theory of Investment". American Economic Review 48 (3): 261–297. http://www.jstor.org/stable/1809766. 
• Modigliani, F.; Miller, M. (1963). "Corporate income taxes and the cost of capital: a correction". American Economic Review 53 (3): 433–443. http://www.jstor.org/stable/1809167. 
• Miles, J.; Ezzell, J. (1980). "The weighted average cost of capital, perfect capital markets and project life: a clarification". Journal of Financial and Quantitative Analysis 15: 719–730. doi:10.2307/2330405. http://www.jstor.org/stable/2330405. 

External links

• Ruben D Cohen "An Implication of the Modigliani-Miller Capital Structuring Theorems on the Relation between Equity and Debt"