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Modligiani and Miller’s Capital Structure Theory

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    Modigliani and Miller’s proposition one states that by introducing debt financing does not change the value of the firm or the value of the firm’s cash-­? flows but only the way that these cash flows of the firm are split between its debt and equity holders. This is the principle of conservation of value: “no change in the investment value of the enterprise as a whole would result from a change in its capitalization. ”

    Therefore, the value of the firm is equal to the value of its debt plus its equity. V = D + E  Modigliani and Miller’s proposition wo states that by introducing debt financing does not change the cost of capital to the firm but merely changes the way risk is divided between debt holders and equity holders. This is the principle of conservation of risk. Because debt has a prior claim on the firm’s cash flows, the introduction of debt increases the risk to shareholders since shareholders’ returns come after those of debt holders. This is effectively a transfer of risk from debt to equity – because debt claims come before those of equity (for the same firm) debt will be less risky (than equity) but the presence of this debt akes equity returns more risky (than for an all equity financed firm).

    The overall risk of the firm remains unchanged, just the way that risk is divided between debt and equity changes as the capital structure changes. ko = (D/V)kd + (E/V)ke and ke = ko + (ko – kd)(D/E) Why does debt make equity more risky? The way I think of it is as a queuing problem. In the case of an all equity firm, the equity holders get all the returns there is no one in front of them in the queue for returns from the company. In the case of a firm with debt, the debt holders have a priority over equity in that debt  holders eceive their returns which are most often a fixed claim over the firm’s cash flows before equity holders receive anything, and equity holders receive their returns last (after everyone else including the debt holders).

    So, the more debt there is, the more ‘claims’ on the firm’s cash flows that come before the equity holders get anything: more people in front of the queue before the equity holders. This presents more risk to equity since the company may not make enough money to pay the equity holders if the company only earns enough to cover the debt costs. Think of the queuing problem  you are waiting in line to buy tickets to your favourite rock band.

    If someone lets more people in front of them in the queue then the queue becomes longer and the tickets may run out before you get to the front of the queue. This is essentially the problem equity holders face if they let too many debt claims in front of them in the queue for returns. The risk to equity holders therefore goes up as more debt claims are placed in front of the equity holders. Therefore, as the D/E increases in this equation ke increases to compensate for this risk. However, just because ke increases does not mean o (or WACC) increases.

    In fact, ko stays constant since the increase in the debt claims merely means debt-­? holders receive a greater proportion of the firm’s cash flows and equity holders less but there is also more debt and less equity in the capital structure so only the way returns are shared is changed by adding debt not the actual cash flows of the firm itself which are defined by its assets or investments into projects which generate the firm’s returns. The Argument Modigliani and Miller’s argument is one of arbitrage.

    For two firms that are alike in all respects and earn the same mount, the value of the two should be the same otherwise if one was worth more than the other it would be profitable to sell the one with a higher value and use the proceeds to buy the other one with a lower value. This profit would be risk free because there would be no overall change in your investment risk. The only point where there is no opportunity to profit from the difference in the value of the two firms is where the two firms have exactly the same value. Hence, proposition one. If the firms have the same value, then they must have the same overall cost of capital (ko) since the value of the irm is equal to the firm’s future cash flows (NOI) discounted at this cost of capital (ko) V = NOI/ko

    Note both firms have the same NOI (earnings) then if V is the same then ko must also be the same! Hence, proposition two. In effect, this means that the firm’s value and risk derives from its investments (and investment decisions) not from the way it is financed. It also means that there is no optimal or ‘best’ way to finance a firm. The Assumptions Modigliani and Miller’s argument is made under the assumptions of perfect capital markets namely that there are no taxes, no transaction costs, perfect nformation, and no bankruptcy costs, and a fixed investment plan.

    What if there are taxes? The presence of taxes may mean that there is a value to having debt since firms’ with debt can claim a tax deduction for the interest payments made. This may mean there is a benefit to having debt because it reduces the company’s tax. It also means that there may be an optimal capital structure that trades off the benefits of debt relative to the costs of bankruptcy. The company should borrow to the point where the benefits of debt start to be offset by the costs of bankruptcy.

    Miller argues that this is not the case since this ignores the fact that the borrower pays interest (and claims a tax deduction) but the lender receives interest (and pays tax on that interest). Therefore, lenders will seek to raise the cost of debt to borrowers in recognition that borrowers get a tax benefit from the debt which is in effect paid for by the lenders.

    The tax benefit from debt is therefore minimal because the borrowers have to pay more for this debt to compensate the lenders who are in effect paying that tax. Moreover, under the imputation tax system where tax paid at the corporate evel is refunded to shareholders at the personal level by franking credits attached to dividends, the tax benefit of debt is minimal. If a company pays 100% of its profits as franked dividends (and shareholders can use all the franking credits) then in effect there is no corporate tax.

    The corporate tax is in effect then only a withholding of the personal taxes to be paid on that corporate income. If there is in effect no corporate tax, then using debt to reduce that (corporate) tax makes no sense.  Under the classical tax system, there may be more benefit for reducing corporate tax since there is no ebate of this tax to shareholders.

    However, Miller’s argument applies equally here to both classical and imputation systems – lenders have to be compensated for the deductions received by borrowers. So, in terms of capital structure decisions, taxes seem to make only a small difference. There is, however, probably some small benefit from the tax deductibility of interest payments on debt. What if there are transaction costs? It will cost money to sell the shares in one company in order to buy shares in the other. Therefore, there are limits on the profitability of selling the shares of the overvalued irm to buy shares in the undervalued firm. This may allow for a range of value differences between the two firms that cannot be arbitraged. Also, it costs money to issue debt and additional equity.

    The cost of retained earnings (reinvestment of earnings) is much lower than the issue of debt or additional equity. Therefore, retained earnings (a form of equity) are ‘cheaper’ than issuing debt or additional equity. (This is the pecking order theory). This means it may be preferable to ‘build equity’ through retained earnings than issue new debt or equity. In such a case, the firm may optimise value y retaining earnings and minimising new issues of debt or equity.

    What if there are bankruptcy costs? The risk for a firm with debt is that debt payments are fixed promises which if not honoured in full leave the company in default. In such a case, the debt holders may either seize control of the company (swap debt for equity) or liquidate the company (sell the assets for cash to pay the debt’s claims). Modigliani and Miller assume that if a company defaults on its debt there is a cost free transfer of ownership from equity to debt holders (i. e. no bankruptcy costs).

    However, bankruptcy costs are ignificant[11] and in effect are borne by debt-­? holders when the company defaults. The anticipated costs of bankruptcy are borne by shareholders prior to any default through higher debt costs which factor the likelihood of default.  Therefore, as a firm’s debt levels move it closer to default, the cost of debt at this point becomes excessively high (because of the bankruptcy costs). In such a case, there is an argument here for ‘safe’ levels of debt that do not place the firm at risk of bankruptcy.

    This will differ for different firms depending upon how variable the underlying cash flows of the usiness are (e. g. retailing food less variable versus mining more variable), and the type of assets (general use assets are more saleable than specific use assets in bankruptcy so may allow the firm to ‘safely’ borrow more, e. g. a houseversus a childcare centre specific and whether the assets are tangible more readily saleable or intangible). What if there is imperfect information? If information is imperfect, then managers know more than shareholders about the firm’s prospects.

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