This action might not be possible to undo. Are you sure you want to continue?
S.L 01 02 03 04 05 06 07 Abstract Introduction About Millar About Modigliani Modigliani – Millar Theorem Historical background of their Theories Propositions: Proposition-01 Proposotion-02 Mathematical Formation of this theory Graphical Formation of this theory Economic consequences of this theory Advantages of this theory Disadvantages of this theory Capital structure Irrelevance The dividend – Irrelevance theory and company valuation Capital structure in perfect market Relevant capital structure Different Agencies cost in this theory Arbitrage of this capital structure Unrealistic premises of this theory The impact of M.M Theories Criticisms of this theory Principle conclusion & Reference PARTICULERS PAGE NO. 1 2 3 5 6 7 7
08 09 10 11 12 13 14 15 16 17 18 19 20 21 22
9 10 11 11 12 13 14 14 15 16 17 17 19 21 23
Abstract A financial theory stating that the market value of a firm is determined by its earning power and the risk of its underlying assets, and is independent of the way it chooses to finance its investments or distribute dividends. Remember, a firm can choose between three methods of financing:
issuing shares, borrowing or spending profits (as opposed to dispersing them to shareholders in dividends). The theorem gets much more complicated, but the basic idea is that, under certain assumptions, it makes no difference whether a firm finances itself with debt or equity. The Modigliani–Miller theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, a company’s value is unaffected by how it is financed, regardless of whether the company’s capital consists of equities or debt, or a combination of these, or what the dividend policy is. The theorem is also known as the capital structure irrelevance principle. A number of principles underlie the theorem, which holds under the assumption of both taxation and no taxation. The two most important principles are that, first, if there are no taxes, increasing leverage brings no benefits in terms of value creation, and second, that where there are taxes, such benefits, by way of an interest tax shield, accrue when leverage is introduced and/or increased. The theorem compares two companies—one unlevered (i.e. financed purely by equity) and the other levered (i.e. financed partly by equity and partly by debt)—and states that if they are identical in every other way the value of the two companies is the same. 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. It is said 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. 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 A) is unleveled: that is, it is financed by equity only. The other (Firm B) 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. Introduction A firm’s value is given by the sum of the present value of forecasted cash flows. Resting on Miller and Modigliani’s (1961) dividend irrelevance proposition, practitioners and some academics do not use actual cash flows; rather, they discount potential dividends, also known as free cash flows or free cash flows to firm (e.g. Damodaran, 2006a,b; Colepand, Koller and Murrin, 2000). Magni and Vélez-Pareja (2009) support the
idea that only actual cash flows should be discounted, whereas potential dividends distort valuation in all cases where excess cash retained is not invested in NPV-neutral investments. In an interesting recent paper, DeAngelo and DeAngelo (2006) revisit Miller and Modigliani’s (1961) paper on dividend policy irrelevance and claim that dividend policy is not irrelevant (see also DeAngelo and DeAngelo, 2007). In the 2006 paper, DeAngelo and DeAngelo (DD) underline the fact that Miller and Modigliani (MM) assume that 100% or more of the free cash flow is distributed to shareholders, thus shunting aside the possibility of retention. According to DD, the assumption of noretention made by MM makes dividend irrelevance a “meaningless tautology .If retention is allowed, then dividend policy is relevant, because managers could choose suboptimal policies by investing in nonzero NPV projects. This paper shows that relevance or irrelevance of dividend policy has not to do with retention; it has to do with the rate of return of the extra funds (excess cash) used for reinvestment or financing: dividend policy is irrelevant if and only if zero-NPV activities are undertaken, with or without assumption of retention. The dichotomy retention/no-retention is nevertheless useful, if it is reinterpreted as a regard for agency problems. Modigliani and Miller, two professors in the 1950s, studied capitalstructure theory intensely. From their analysis, they developed the capital-structure irrelevance proposition. Essentially, they hypothesized that in perfect markets, it does not matter what capital structure a company uses to finance its operations. The MM study is based on the following key assumptions: i) No taxes ii) No transaction costs iii) No bankruptcy costs Equivalence in borrowing costs for both companies and investors Symmetry of market information, meaning companies and investors have the same informationNo effect of debt on a company's earnings before interest and taxes In this simplified view, it can be seen that without taxes and bankruptcy costs, the WACC should remain constant with changes in the company's capital structure. For example, no matter how the firm borrows, there will be no tax benefit from interest payments and thus no changes/benefits to the WACC. Additionally, since there are no changes/benefits from increases in debt, the capital structure does not influence a company's stock price, and the capital structure is therefore irrelevant to a company's stock price. About Millar
Merton Howard Miller (May 16, 1923 – June 3, 2000) was the coauthor of the Modigliani-Miller theorem which proposed the irrelevance of debt-equity structure. He shared the Nobel Memorial Prize in Economic Sciences in 1990, along with Harry Markowitz and William Sharpe. Miller spent most of his academic career at the University Of Chicago Booth School Of Business. Early years Miller was born Jewish, in Boston, Massachusetts to Joel and Sylvia Miller, an attorney and housewife. He worked during World War II as an economist in the division of tax research of the Treasury Department, and received a Ph.D. in economics from Johns Hopkins University, 1952. His first academic appointment after receiving his doctorate was Visiting Assistant Lecturer at the London School of Economics. Career In 1958, at Carnegie Institute of Technology (now Carnegie Mellon University), he collaborated with his colleague Franco Modigliani there to write a paper on “The Cost of Capital, Corporate Finance and the Theory of Investment.” This paper urged a fundamental objection to the traditional view of corporate finance, according to which a corporation can reduce its cost of capital by finding the right debt-to-equity ratio. According to the Modigliani-Miller theorem, on the other hand, there is no right ratio, so corporate managers should seek to minimize tax liability and maximize corporate net wealth, letting the debt ratio chips fall where they will. The way in which they arrived at this conclusion made use of the "no arbitrage" argument, i.e. the premise that any state of affairs that will
allow traders of any market instrument to create a riskless money machine will almost immediately disappear. They set the pattern for many arguments based on that premise in subsequent years. Miller wrote or co-authored eight books. He became a fellow of the Econometric Society in 1975 and was president of the American Finance Association in 1976. He was on the faculty of the University Of Chicago Graduate School Of Business from 1961 until his retirement in 1993, although he continued teaching at the school for several more years. His works formed the basis of the "Modigliani-Miller Financial Theory". He served as a public director on the Chicago Board of Trade 1983-85 and the Chicago Mercantile Exchange from 1990 until his death in Chicago on June 3, 2000. Personal life Miller was married to Eleanor Miller, who died in 1969. He was survived by his second wife, Katherine Miller, and by three children from his first marriage and two grandsons’ three children by his first marriage: Pamela (1952), Margot (1955), and Louise (1958). About Modigliani
Franco Modigliani (June 18, 1918 – September 25, 2003) was an Italian economist at the MIT Sloan School of Management and MIT Department of Economics, and winner of the Nobel Memorial Prize in Economics in 1985.
Life and career Born in Rome, Italy, he left Italy in 1939 because of his Jewish origin and antifascist views. He first went to Paris with the family of his thengirlfriend, Serena, whom he married in 1939, and then to the United States. From 1942 to 1944, he taught at Columbia University and Bard College as an instructor in economics and statistics. In 1944, he obtained his D. Soc. Sci. from the New School for Social Research working under Jacob Marschak. In 1946, he became a naturalized citizen of the United States, and in 1948, he joined the University of Illinois at UrbanaChampaign faculty. When he was a professor at the Graduate School of Industrial Administration of Carnegie Mellon University in the 1950s and early 1960s, Modigliani made two path-breaking contributions to economic science: Along with Merton Miller, he formulated the important ModiglianiMiller theorem in corporate finance. This theorem demonstrated that under certain assumptions, the value of a firm is not affected by whether it is financed by equity (selling shares) or debt (borrowing money). . In 1962, he joined the faculty at MIT, achieving distinction as an Institute Professor, where he stayed until his death. In 1985 he received MIT's James R. Killian Faculty Achievement Award. Modigliani also coauthored the textbooks, "Foundations of Financial Markets and Institutions" and "Capital Markets: Institutions and Instruments" with Frank J. Fabozzi of Management. In the 1990s he teamed up with Francis Vitagliano to work on a new credit card, and he also helped to oppose changes to a patent law that would be harmful to inventors. Modigliani was a trustee of the Security. For many years, he lived in Belmont, Massachusetts; he died in Cambridge, Massachusetts. 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. 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 of this theory 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. Proposition I: With taxes where VL is the value of a levered firm. VU is the value of an unlevered firm. TCD is the tax rate (TC) x the value of debt (D) the term TCD 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.
where VU is the value of an unlevered firm = price of buying a firm composed only of equity, and VL 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. 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 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: i) Corporations are taxed at the rate TC on earnings after interest, ii) No transaction costs exist, and iii) 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. Proposition II with risky debt. As leverage (D/E) increases, the WACC (k0) stays constant i) ke is the required rate of return on equity, or cost of equity. ii) k0 is the company unlevered cost of capital (ie assume no leverage). Iii) kd is the required rate of return on borrowings, or cost of debt. iv) 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).
Mathamatical formation of this proposition
where rE 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). rD is the required rate of return on borrowings, or cost of debt. D / E is the debt-to-equity ratio. Tc 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
Graphical formaion of this proposition
Proposition II with risky debt. As leverage (D/E) increases, the WACC (k0) stays constant. ke is the required rate of return on equity, or cost of equity. k0 is the company unlevered cost of capital (ie assume no leverage). kd is the required rate of return on borrowings, or cost of debt.
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). Economic consequences of this theory 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. Advantages of this theory In practice, it’s fair to say that none of the assumptions are met in the real world, but what the theorem teaches is that capital structure is important because one or more of the assumptions will be violated. By applying the theorem’s equations, economists can find the determinants of optimal capital structure and see how those factors might affect optimal capital structure To a firm, the most significant everlasting theme is getting the maximum profit with the lowest cost and the least risk. Anybody who studies Corporate Finance knows what an important role the capital structure plays in reducing a firmfs costs and risks. Capital structure is the ratio of equity and debt. A bad financing decision may result in many forms of higher direct or indirect costs, such as lower stock price, higher cost of capital and lost growth opportunities, increased probability of bankruptcy, higher agency cost and possible wealth transfers from one group of investors to another (Sharma, Kamath and Tuluca, 2003, p. 63). Therefore, how a manager finances a firm becomes a key step to a firm. It is also an important part of Corporate Finance and Managerial Finance. The cornerstone theory of the capital structure is the Modigliani-Miller theory (thereafter MM). MM was developed by two economists, Franco Modigliani, a professor at Massachusetts Institute of Technology, and Merton Miller, a professor at University of Chicago Graduate School of
10 | P a g e
Business (Gifford, 1998). By this main contribution, Modigliani won the Nobel Prize in Economics in 1985 and Miller won the Nobel Prize in Economics in 1990 (Wall Street Jo Disadvantages of this theory Modigliani and Miller’s theorem, which justifies almost unlimited financial leverage, has been used to boost economic and financial activities. However, its use also resulted in increased complexity, lack of transparency, and higher risk and uncertainty in those activities. The global financial crisis of 2008, which saw a number of highly leveraged investment banks fail, has been in part attributed to excessive leverage ratios. Capital structure irrelevance Simple financial theory shows that the total value of a company should not change if its capital structure does. This is known as capital structure irrelevance, or Modigliani-Miller (MM) theory. Total value is the value of all its sources of funding, this is similar to a simple (debt + equity) enterprise value. The MM argument is simple, the total cash flows a company makes for all investors (debt holders and shareholders) are the same regardless of capital structure. Changing the capital structure does not change the total cash flows. Therefore the total value of the assets that give ownership of these cash flows should not change. The cash flows will be divided up differently so the total value of each class of security (e.g. shares and bonds) will change, but not the total of both added together. Looking at this another way, if you wanted to buy a company free of its debt, you would have to buy the equity and buy, or pay off, the debt. Regardless of the capital structure you would end up owning the same streams of cash flows. Therefore the cost of acquiring the company free of debt should be the same regardless of capital structure. Furthermore, it is possible for investors to mimic the effect of the company having a different capital structure. For example, if an investor would prefer a company to be more highly geared this can be simulated by buying shares and borrowing against them. An who investor would prefer the company to be less highly geared can simulate this by buying a combination of its debt and equity. MM theory depends on simplifying assumptions such as ignoring the effects of taxes. However, it does provide a starting point that helps understand what is, and is not, relevant to why capital structure does seem to matter to an extent. The different tax treatments of debt and equity are
11 | P a g e
part of the answer, as are agency problems (conflicts of interest between shareholders, debt holders and management). There are extensions to MM theory which suggest that the actions of market forces, together with the tax treatment of debt and equity income in the hands of investors, means that for most companies the gains that can be made by adjusting capital structure will be fairly small. Given that companies would not deliberately adopt inefficient capital structures, we can assume that all companies have roughly equivalently good capital structures So from a valuation point of view we can reasonably assume that capital structure is irrelevant. Using enterprise value based valuation ratios such as EV/EBITDA and EV/Sales implicitly assume that capital structure is irrelevant. Capital structure irrelevance is closely related to dividend irrelevance. Much like their work on the capital-structure irrelevance proposition, Modigliani and Miller also theorized that, with no taxes or bankruptcy costs, dividend policy is also irrelevant. This is known as the "dividend-irrelevance theory", indicating that there is no effect from dividends on a company's capital structure or stock price. MM's dividend-irrelevance theory says that investors can affect their return on a stock regardless of the stock's dividend. For example, suppose, from an investor's perspective, that a company's dividend is too big. That investor could then buy more stock with the dividend that is over the investor's expectations. Likewise, if, from an investor's perspective, a company's dividend is too small, an investor could sell some of the company's stock to replicate the cash flow he or she expected. As such, the dividend is irrelevant to investors, meaning investors care little about a company's dividend policy since they can simulate their own. The Dividend-Irrelevance Theory and Company Valuation In the determination of the value of a company, dividends is often used. However, MM's dividend-irrelevance theory indicates that there is no effect from dividends on a company's capital structure or stock price. MM's dividend-irrelevance theory says that investors can affect their return on a stock regardless of the stock's dividend. For example, suppose, from an investor's perspective, that a company's dividend is too big. That investor could then buy more stock with the dividend that is over his or her expectations. Likewise, if, from an investor's perspective, a company's dividend is to small, an investor could sell some of the company's stock to replicate the cash flow he or she expected. As such, the dividend is irrelevant to investors, meaning investors care little about a company's dividend policy since they can simulate their own..
12 | P a g e
The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital structure, though it is generally viewed as a purely theoretical result since it disregards many important factors in the capital structure decision. The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. This result provides the base with which to examine real world reasons why capital structure is relevant, that is, a company's value is affected by the capital structure it employs. Some other reasons include bankruptcy costs, agency costs, taxes, and information asymmetry. This analysis can then be extended to look at whether there is in fact an optimal capital structure: the one which maximizes the value of the firm. Capital structure in a perfect market Consider a perfect capital market (no transaction or bankruptcy costs; perfect information); firms and individuals can borrow at the same interest rate; no taxes; and investment decisions aren't affected by financing decisions. Modigliani and Miller made two findings under these conditions. Their first 'proposition' was that the value of a company is independent of its capital structure. Their second 'proposition' stated that the cost of equity for a leveraged firm is equal to the cost of equity for an unrevealed firm, plus an added premium for financial risk. That is, as leverage increases, while the burden of individual risks is shifted between different investor classes, total risk is conserved and hence no extra value created. Their analysis was extended to include the effect of taxes and risky debt. Under a classical tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure, then would be to have virtually no equity at all. Relevant Capital structure Trade-off theory Trade-off theory allows the bankruptcy cost to exist. It states that there is an advantage to financing with debt (namely, the tax benefits of debt) and that there is a cost of financing with debt (the bankruptcy costs and the financial distress costs of debt). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. Empirically, this theory may explain differences in D/E ratios between industries, but it doesn't explain differences within the same industry.
13 | P a g e
Pecking order theory Pecking Order theory tries to capture the costs of asymmetric information. It states that companies prioritize their sources of financing (from internal financing to equity) according to the law of least effort, or of least resistance, preferring to raise equity as a financing means “of last resort”. Hence: internal financing is used first; when that is depleted, then debt is issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required (equity would mean issuing shares which meant 'bringing external ownership' into the company). Thus, the form of debt a firm chooses can act as a signal of its need for external finance. The pecking order theory is popularized by Myers (1984) when he argues that equity is a less preferred means to raise capital because when managers (who are assumed to know better about true condition of the firm than investors) issue new equity, investors believe that managers think that the firm is overvalued and managers are taking advantage of this over-valuation. As a result, investors will place a lower value to the new equity issuance. Tax-PreferenceTheory Taxes are important considerations for investors. Remember capital gains are taxed at a lower rate than dividends. As such, investors may prefer capital gains to dividends. This is known as the "tax Preference theory". Additionally, capital gains are not paid until an investment is actually sold. Investors can control when capital gains are realized, but, they can't control dividend payments, over which the related company has control. Capital gains are also not realized in an estate situation. For example, suppose an investor purchased a stock in a company 50 years ago. The investor held the stock until his or her death, when it is passed on to an heir. That heir does not have to pay taxes on that stock's appreciation. Agency Costs There are three types of agency costs which can help explain the relevance of capital structure. • Asset substitution effect: As D/E increases, management has an increased incentive to undertake risky (even negative NPV) projects. This is because if the project is successful, share holders get all the upside, whereas if it is unsuccessful, debt holders get all the downside. If the projects are undertaken, there is a chance of firm value decreasing and a wealth transfer from debt holders to share holders. • Underinvestment problem (or Debt overhang problem): If debt is risky (e.g., in a growth company), the gain from the project will accrue to debt holders rather than shareholders. Thus, management
14 | P a g e
has an incentive to reject positive NPV projects, even though they have the potential to increase firm value. Free cash flow: unless free cash flow is given back to investors, management has an incentive to destroy firm value through empire building and perks etc. Increasing leverage imposes financial discipline on management.
Arbitrage of this capital structure Similar questions are also the concern of a variety of speculator known as a capital-structure arbitrageur, see arbitrage. A capital-structure arbitrageur seeks opportunities created by differential pricing of various instruments issued by one corporation. Consider, for example, traditional bonds and convertible bonds. The latter are bonds that are, under contracted-for conditions, convertible into shares of equity. The stock-option component of a convertible bond has a calculable value in itself. The value of the whole instrument should be the value of the traditional bonds plus the extra value of the option feature. If the spread (the difference between the convertible and the nonconvertible bonds) grows excessively, then the capital-structure arbitrageur will bet that it will converge. Unrealistic Premises of this theory The premises behind the elegant mathematics of the M&M theory were unrealistic. Some of the assumptions were: Perfect Markets: The capital market is perfect. No single buyer or seller can influence security prices or interest rates. (The Federal Reserve Open Market Committee can not manipulate the price of treasury bonds and management cannot force prices upwards with stock buybacks.) Perfect Knowledge: Information on securities is free and perfect. Investors all know with “perfect certainty” what the future will bring. (Standard & Poor’s and Moody’s must go out of business. Companies never lie and provide complete and full information at all times. Corporate profits can be predicted with confidence for one hundred years or more.) Free Transactions: There are no brokerage fees, dealer spreads, transfer taxes, or other transaction costs. (Presumably, there would be no brokers, since there are no fees for intermediation. There also would be no stock exchanges or clearinghouses.)
15 | P a g e
Tax Neutrality: There is no tax difference between debt and equity, or between distributed and undistributed profits. Taxes are the same for all types of investors. There is no tax on capital gains. (This means there would be no tax on dividends or interest. Taxes on dividends paid to corporations, Keogh plans, and individual investors would be the same.) Indifference to Cash: Investors are just as happy with unrealized paper profits as with cash dividends. This is defined as “rational behavior”. (Workers in the real world of finance, at the time the theory was advanced, measured the value of securities by discounting real cash flows, not paper profits.) Indifference to Risk: Investors will always prefer to make decisions that maximize wealth (paper profits), even if this is more risky than alternatives. Debt is risk free and its cost is insensitive to changes in interest rates or risk of bankruptcy. Indifference to Loan Conditions: The terms of financing are irrelevant. (Managers may finance long-term investments with thirty-day bank loans with impunity.) All Players Think Alike: There is no difference in the behavior or goals of controlling shareholders, minority investors, professional managers, and institutional investors. Stock and Bond Equivalence. There is no difference between stocks and bonds. (Investors have no preference for the contractual promise of bonds, as compared to lack of corporate liability on equities.)What is most impressive about the M&M Theory is that its assumptions are so divorced from actual life as to be absurd. Professors Miller and Modigliani might as well have proposed a Jellybean Theory in which investors were made up of gum drops that would be soon eaten by a giant rabbit. The Impact of M&M Theories Prior to the 1970s, the M&M Theory would have had little effect on financial markets, because business people paid scant attention to PhDs, unless they were engaged in building atomic bombs or other truly scientific endeavors. However, stiff job competition in the dismal seventies created an advantage for job-seekers with MBA degrees. Consequently, hoards of young MBAs indoctrinated by theoretical economists (without the benefit of on-the-job training in business) began to fill lower management echelons of banks and industrial corporations. These brain-washed young men and women brought arrogant notions of a New World Order, singing of betas, alphas, and non-systemic risk.
16 | P a g e
Unfortunately, M&M Theory was not only devoid of a basis in reality, but it was also of slight ethical merit. The M&M Theory had a pernicious effect on corporate governance and investment markets: Price Inflation Justified. It became fashionable to value equities by discounting future earnings (rather than dividends) and, in doing this, to use market interest rates (rather than an investor’s own expectations). This inflated the theoretical value of stocks many-fold, justifying priceearnings ratios of fifty and higher. By focusing on earnings, more easily falsified than dividends, corporate managers were tempted to pump up financial reports in order to increase the value of stock options. John Burr William’s formula already carried a dangerous seed of overvaluing growth stock, with the Petersburg Paradox. But the M&M Theory went beyond this, making it possible for academics and Wall Street hucksters to claim that stocks were still cheap even in mid-2000, when the Great Bubble was about to pop. Riskier Banking. Conservative bank lending practices of self-liquidating loans were now passé, since it was theoretically proper to separate the use of funds from the terms of the funding. This opened wide the door to the roll-over of bank loans as a substitute for equity, a major cause of the financial crises in Asia in 1997. Dividends Despised. Stockholders no longer had a theoretical basis to demand dividends. Capital gains were supposedly just as good, even when these gains were the result of manipulation through stock buybacks. Total return (including paper profits) became the preferred way of measuring investment performance. Without the anchor of cash dividend yields linked to bond yields, equities became increasingly risky and volatile. Leverage Enthroned. A high debt load relative to equity was now acceptable, since the M&M Theory “proved” that the capital structure of a firm was irrelevant. Paper Profits, Not Cash. Since temporary, unrealized capital gains were supposedly just as good as cash dividends, there was intellectual justification for stock buyback programs and the pilfering of corporate assets by professional managers. In claiming that corporate capital structure and dividends were irrelevant, the M&M Theory was the economic equivalent of the moral relativism and nihilism that had infected American universities.
17 | P a g e
A corporate manager could shuck the traditional fiduciary responsibility to reward investors with dividends, by claiming that capital gains were just as good. Bankers could boost profits by pretending that short-term loans could be liquidated at will, when in fact corporations needed perpetual roll-overs of bank debt to maintain this substitute for equity. Criticisms of this theory 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. The Principal Conclusion for Dividend Policy
The dividend-irrelevance theory, recall, with no taxes or bankruptcy costs, assumes that a company's dividend policy is irrelevant. The dividend-irrelevance theory indicates that there is no effect from dividends on a company's capital structure or stock price. MM's dividend-irrelevance theory assumes that investors can affect their return on a stock regardless of the stock's dividend. As such, the dividend is irrelevant to an investor, meaning investors care little about a company's dividend policy when making their purchasing decision since they can simulate their own dividend policy. Reference:
18 | P a g e
Aghion, P. and Bolton, P. (1992). An Incomplete Contracts Approach to Financial Contracting. Review of Economic Studies, 59, 473-94. Alchian, A. and Demsetz, H. (1972). Production, Information Costs and Economic Organization. American Economic Review, 62, 777-95. Allen, F., Bernardo, A. and Welch, I. (2000). A Theory of Dividends Based on Tax Clienteles. Journal of Finance, LV, 2499-2536. Allen, F. and Gale, D. (1988). Optimal Security Design. Review of Financial Studies, 1, 229-263. Allen, F. and Gale, D. (1991). Arbitrage, Short Sales and Financial Innovation. Econometrica, 59, 1041-68. Bhattacharya, S. (1979). Imperfect Information, Dividend Policy, and the ‘Bird in the Hand’ Fallacy,” Bell Journal of Economics, 10, 259-70.
19 | P a g e
This action might not be possible to undo. Are you sure you want to continue?
We've moved you to where you read on your other device.
Get the full title to continue listening from where you left off, or restart the preview.