Corporate Finance Contribution made by Modigliani and Miller to Corporate Finance Theory and Practice

Corporate Finance
Contribution made by Modigliani and Miller to
Corporate Finance Theory and Practice

1.0 Introduction:
In general a firm has the liberty to choose among many alternative capital structures depending on the business requirements. It can arrange for a large amount of debt and a smaller own capital or it can decide to have a large capital base and a smaller debt exposure. On the means of financing the required capital, the firm has a variety of choices like floating rate preferred stock, warrants, convertible bonds, caps and callers. It can arrange lease financing, bond swaps and forward contracts. Due to the numerous choices available to the firm, there can be an endless capital structures which the firm can resort to. However it is to be ascertained whether the way in which the firm’s capital structure is arranged will have an effect on the cost of capital. It also is to found out considering the cost of capital what would be the optimal capital structure. If the firm’s capital structure comprises of a particular mix securities, whether such mix affects the market prices of the securities of that particular firm is another question that needs to be analysed while deciding the capital structure. The issue of relationship between the capital structure and the market price of the firm’s stock has always been debated under the theory of capital structure. In this respect economists Franco Modigliani and Merton Miller have demonstrated through their theories that with perfect financial markets capital structure of the firm is irrelevant. This paper details the contribution made by these economists to the Corporate Finance and Theory in the area of capital structure.   
2.0 Traditional Approach to Valuation and Leverage:
In any corporate financing using a higher proportion of debts to equity are known as ‘leverage’. The term leverage is used since the proportion of higher debts acts as a lever in that the debt enables the available amount of equity to carry more than its weight in assets. “The traditional approach to stock valuation and leverage assumes that there is an optimal capital structure and that the firm can increase the total value of the firm through the judicious use of the leverage. The approach suggests that the firm initially can lower its cost of capital and raise its total value through leverage. Thus the traditional approach assumed that the firms with higher leverage would have higher stock prices.” (James C. Van Horne)
3.0 The Modigliani-Miller Theorem
In quite contrast to the traditional approach the Modigliani and Miller (MM) theory argues that while the corporations can not, the individuals by their actions will be able to influence the leverage of the company. According to the MM theorem the total value of the firm is based on the value of its net assets and not the way in which the firm’s capital is structured. Investors in pursuit of maximizing the return on their investments would evaluate the physical and intrinsic value of the assets of the company irrespective of the way in which the firm is financed. MM has contributed the following propositions in the sphere of corporate financing and for the valuation of the firms.
“On Leverage and the Value of the Firm
MM Proposition 1: The value of a firm is independent of its leverage.
On Leverage and the firm’s cost of capital
MM Proposition 2: A firm’s cost of equity is a linear function of its debt/equity ratio.

On Dividend Policy
MM Proposition 3: The value of a firm is independent of its dividend Policy.” (Corporate Finance)

3.1 Assumptions of the MM Approach:
MM in their original position advocates that the relationship between the leverage and the cost of capital is explained by the net operating income approach. They make a formidable attack on the traditional approach by offering behavioural justification for having the cost of capital remain constant throughout all degrees of leverage. For making the propositions MM has made certain assumptions. They are:
“Capital markets are perfect: Information is costless and is readily available to all investors. There are no transaction costs and all securities are infinitely divisible. Investors are assumed to be rational and will also behave accordingly.
The average expected future operating earnings of a firm are represented by subjective random variables. It is assumed that the expected values of the probability distribution of all investors are the same. The MM illustration implies that the expected values of the probability distributions of expected operating earnings for all future periods are the same as present operating earnings.
Firms can be categorized into ‘equivalent return’ classes. All firms within a class have the same degree of business risk.
The absence of corporate income taxes was originally assumed by MM (later this assumption was removed by MM)” (James C. Van Horne)

3.2 MM Proposition 1: ‘The value of a firm is independent of its leverage’.

“In competitive, transaction costless, information efficient markets, with no taxes, the market value of the firm (i.e., market value of all of its securities) is independent of the firm’s capital structure.  That is,  =  where  is the value of the firm if it has debt,  is the value of the firm if it has no debt.” (Brealey, Myers and Allen, Chapter 17)

3.2.1 Logic of M-M Proof:

The proof of this MM proposition is based on the arbitrage property of perfect markets as indicated below:
Arbitrage Property:  Two identical assets must have the same market price. Two assets are identical if either can be converted into the other.
Let firm U be an unlevered firm and let firm L be an identical firm if levered (or be the same firm if levered); U and L differ only in that L is levered.   is the market value of firm U  (therefore  is also the market value of the equity of firm U since it is unlevered);   and are the market values, respectively, of the equity and debt of firm L, and firm value =  + .
Compare buying percent P of firm L with the following: buying percent P of the equity (shares) of firm U plus personal borrowing of amount P  (using the shares of firm U as collateral).  Exhibit 1 shows that the incomes of the two “strategies” are identical.

Exhibit 1 Convert U into L using [2]
Strategy
Net Investment of the Strategy
Income
[1]  Buy percent P of equity of firm L
P
P [Profit – Interest]
[2]  Buy percent P of equity of firm U and borrow amount [P ]
P  – P
P Profit – P Interest =
 = P [Profit – Interest]

Since we can use strategy [2] to create the stock under strategy [1], strategy [2] must be at least as good as strategy [1], and therefore we must be willing to pay at least as much for strategy [2] as for strategy [2].  That is,

             P  – P  ³ P ,

which implies that:

                                     ³  +  =                                                                                          (1)

Now we will show that we can convert L into U.  Compare two strategies: [1¢] Buy P percent of firm U;  [2¢] Buy P percent of the shares of firm L, and buy percent P of the debt of firm L.  Exhibit 2 shows that the incomes of the two strategies are identical.

Exhibit 2 Convert L into U [using [2¢])
Strategy
Net Investment of the strategy
Income
[1¢] Buy percent P of firm U equity
P
P Profit
[2¢] Buy percent P of firm L debt and
       percent P of firm L equity
P  + P = P
P [Profit – Interest] + P Interest
 = P Profit

Since we can use strategy [2¢] to create the stock under strategy [1¢], strategy [2¢] must be at least as good as strategy [1¢], and therefore we must be willing to pay at least as much for strategy [2¢] as for strategy [2¢].  That is,
             P  ³ P
which implies that:
                                           ³                                                                                              (2)
The only way for (1) and (2) to hold is for:
                                           =                                                                                           (3)
which is M-M Proposition 1.” (Modigliani Miller Propositions)

This is perhaps the most important contribution of MM to corporate finance theory. In fact it is generally considered as the beginning point of the modern managerial finance. Before MM advocated this theory the effect of leverage on the value of the firm was considered complex and convoluted. MM shows a blindingly simple result. If levered firms are priced too high the investors will simply borrow on their personal accounts to buy shares in the unlevered firms. This substitution is often referred to as ‘homemade leverage’. It is proposed that as long as individuals borrow on the same term as the firms, they can duplicate the effects of corporate leverage on their own.
The MM result hinges on the assumption that individuals can borrow as cheaply as corporations. If alternatively individuals can only borrow at a higher rate, one can easily show that corporations can increase the firm value by borrowing.
3.3 MM Proposition 2: ‘A firm’s cost of equity is a linear function of its debt/equity ratio’.
“The proposition states that a higher debt – to – equity ratio leads to a higher required rate of return on equity, because of the higher risk involved for equity holders in a company with debt.”
This proposition also holds the assumption of a perfect market. According to this proposition the firm can have a 100 percent debt in its capital structure for gaining the maximum benefit of tax shield. But in reality capital structure with a 100 percent debt component is not possible.”
(Abubakr Saeed)
“In competitive, transaction costless, information efficient markets, with corporate tax-deductibility of interest, the market value of the firm (i.e., market value of all of its securities) equals:
  =  + T
where  is the value of the firm if it has debt,  is the value of the firm if it has no debt, T is the corporate tax savings per dollar of debt, and  is the market value of the firm’s debt.” (Brealey, Myers and Allen, Chapter 17)
3.4 MM Proposition 3: ‘The value of a firm is independent of its dividend Policy’.

MM proposition – 3 focuses on dividend payments and value of a firm. It states that “Under certain conditions the value of a firm is independent of its dividend policy. Expressed more loosely, two identical firms that belong to same risk class will have equal market value even they have different dividend policies.” (Abubakr Saeed)
With respect to this proposition the theory assumes the following:
There are neither taxes nor brokerage fees and no single participant can affect the market price of the security through his or her trades. These are the conditions that exist in a perfect market.
All individuals have the same beliefs concerning future investments, profits, and dividends.
The investment policy of the firm is set ahead of time and is not altered by changes in dividend policy.
4.0 Taxes and Capital Structure:

The irrelevance of capital structure rests on an absence of market imperfections. In other words the market is assumed to be perfect. Hence irrespective of the way in which the capital pie of the firm is divided between debt and equity there is a conservation of  value, so that the sum of the parts is always the same. This implies nothing is lost or gained in the slicing. To the extent there are capital market imperfections, however, changes in the capital structure of a company may affect the total size of the pie. That is to say, the firm’s valuation and cost of capital may change with the changes in capital structure. One of the most important imperfections that need consideration is the presence of corporate taxes.
The advantage of a debt in the context of corporate taxes is that interest payments are deductible as an expense. They reduce the incidence of taxation at the corporate level, whereas dividends or retained earnings associated with stock are not deductible by the corporation for tax purposes.
Consequently the total amount of payments available for both the creditors and the stockholders is greater if debt is employed.
5.0 Dividend Policy and the Valuation of the Firm:

The dividend policy of the firm is irrelevant in a perfect market because the shareholder can effectively undo the firm’s dividend strategy. If a shareholder receives a greater dividend than desired he or she can reinvest the excess. Conversely if the shareholder receives a smaller dividend than desired he or she can sell off extra shares of stock. This concept was developed by MM and is similar to that of ‘homemade leverage’.
In the MM approach it has been held that:
Dividends are relevant and
Dividend Policy is irrelevant
The first statement is just a statement that follows the common understanding. The investors would like to receive higher dividends to lower rates at any point of time if the dividend level is held constant at every other date. Therefore it follows that if the dividend per share at a given date is raised while the dividend per share is held constant at every other date, the stock price is sure to increase. This act can result in the management action to improve the productivity, increase tax savings or strengthen product marketing.
The second statement that ‘dividend policy is irrelevant’ is understandable only under a situation where the dividend policy results in holding on the dividend level per share constant at all other  times and raise the dividend on any particular date. Rather the dividend policy deals with the trade-off between dividends at one point of time and dividend on other dates.
Thus it can be observed that the dividend policy does not matter. That is managers deciding to either increase or decrease the dividend do not affect the current value of the firm. This theory is an important and powerful contribution by MM to the field of corporate finance. It is considered as a classic theory in the modern finance. With relatively fewer assumptions the theory has proved a surprising result and the result is also proved to be true.
Therefore it also follows that an increase in dividends through issuance of new shares neither helps nor hurts the shareholders. Similarly a reduction in dividends through repurchase neither helps nor hurts the shareholders.
There are a number of justifications for dividends even in a world with personal taxes:
Investors in no-dividend stocks incur transaction costs when selling off shares for current consumption.
Managers may increase dividends to boost current stock price, even at the expense of projects with positive NPVs. This strategy is called signaling.
Managers acting on behalf of stockholders can pay dividends to keep cash from bondholders. The board of directors also acting on behalf of stockholders can use dividends to reduce the cash available to spendthrift mangers.

6.0 MM Approach – an Interpretation:

“The MM approach results indicate that the managers cannot change the value of a firm by reworking the firm’s capital structure. Though this idea was considered as revolutionary when it was originally proposed in the late 1950s the MM model and arbitrage proof has since met with wide acclaim.” (Ross Westerfield Jaffe)
MM argue that the firm’s overall cost of capital can not be reduced as the debt is substituted for equity even though debt appears to be cheaper than equity. The reason for this is that as the firm adds debt, the remaining equity becomes more risky. As this risk rises the cost of equity capital rises as a result. The increase in the cost of remaining equity capital off-sets the higher proportion of the firm financed by low-cost debt. In fact, MM prove that the two effects exactly offset each other, so that both the value of the firm and the firm’s overall cost of capital are invariant to the leverage.
Although the scholars and economists are always fascinated with far-reaching theories, the real world business managers do not follow MM for making capital structure decisions. Unfortunately for the theory all companies in certain industries such as banking choose high debt-to-equity ratios. Conversely companies in other industries such as pharmaceuticals choose low debt-to-equity ratios. In fact almost any industry has a debt-equity-ratio as a standard which the firms in that industry adopt for structuring their capital bases. Thus companies do not appear to be selecting their degree of leverage in a frivolous or random manner. Because of this financial economists including MM have argued that real-world factors may have been left out of the theory.

7.0 Conclusion:

The paper started with the discussion on the approach of fixing an optimal capital structure for maximizing the value of the firm. However the in a world of no taxes the Modigliani – Miller Proposition I proves that the value of the firm is unaffected by the debt – to – equity ratio. In other words a firm’s capital structure is a matter of indifference in that world. The authors obtain their results by showing that either a high or low corporate ratio of debt to equity can be offset by homemade leverage. The result however is based on the assumption that individuals can borrow at the same rates as corporations. The MM theory also implies that the expected rate of return on equity also known as the cost of equity or the required rate of return on equity is positively related to the firm’s leverage. It is observed that while the work of MM is quite elegant, it does not explain the empirical findings on capital structure very well. MM imply that the capital structure decision is a matter of indifference, while the decision appears to be weighty one in the real world. For it’s applicability in the real world the corporate taxes need to be cosniderd.

References:

Abubakr Saeed (2007) ‘The Determinants of Capital Structure in Energy Sector’
http://www.bth.se/fou/cuppsats.nsf/all/1aee0e254c0e448dc125730f001c295d/$file/Final%20Thesis_1st%20July.pdf.
Corporate Finance ‘The Modigliani-Miller Theorems’ http://courses.essex.ac.uk/ec/ec372/lec19.pdf.
James C. Von Horne ‘Financial Management Policy’ Edition 12
Prentice-Hall of India Private Limited 2004
Modigliani Miller Propositions
http://faculty.washington.edu/lschall/HANDOUTS/Debt%20Policy/MODIGLIANI-MILLER%20PROOF%20OF%20D-E%20IRRELEVANCE.doc.
R. A. Brealey, S. C. Myers, F. Allen, Principles of Corporate Finance, Chapter 17 8th edition, McGraw-Hill, 2006
Ross A. Stephen, Westerfield W.Randolph and Jaffe Jaffrey ‘Corporate Finance’ Edition 7
Tata McGraw –Hill 2004