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THE MODIGLIANI-MILLER THEOREM

Overview:

The Modigliani-Miller Theorem

Illustration:

Capital Structure

Dividend Policy

Using MM sensibly:

Practitioners

FINANCIAL POLICY

CAPX

R&D

Etc.

Financial policy:

Financing decisions: Internal funds (i.e. cash reserves), debt, trade credit, equity, etc.

Capital structure

Long-term vs. short-term debt

Floating vs. xed interest rate debt

Debt’s currency denomination

Dividend, share repurchases, etc.

Risk management (e.g. interest rate hedging)

Etc.

MODIGLIANI-MILLER IRRELEVANCE THEOREM

Modigliani and Miller (1958, 1961)

Modigliani-Miller Theorem:

Under some assumptions, a rm’s value is independent of its nancial policy

Assumptions:

1. Perfect nancial markets:

Competitive: Individuals and rms are price-takers

Frictionless: No transaction costs, etc.

All agents are rational

2. All agents have the same information

3. A rm’s cashows do not depend on its nancial policy (e.g. no bankruptcy costs)

4. No taxes

No point studying corporate nancial policy

Proof

Arbitrage opportunity: Ability to make a risk-free prot by trading nancial claims

Equilibrium No arbitrage opportunity If and are risky cashow streams

Firm value:

(+ ) = () + ()

By denition, a rm’s value is the sum of the values of all its nancial claims

The cashows all its claims receive must add up to the total cashow its assets generate

Value additivity The rm’s value must equal that of the assets’ cashow stream

Intuition: Economic equivalent of the accounting identity between assets and liabilities

Consider identical rms with dierent nancial policies:

Same assets Same cashow streams Same rm values

The original propositions:

Remarks

MM-Proposition I (MM 1958): A rm’s total market value is independent of its capital structure

MM-Proposition II (MM 1958): A rm’s cost of equity increases with its debt-equity ratio

Dividend Irrelevance (MM 1961): A rm’s total market value is independent of its dividend policy

Investor Indierence (Stiglitz 1969): Individual investors are indierent to all rms’ nancial policies

Dierent approaches:

MM’s proof requires two identical rms

Alternatives:

Arbitrage approach with a single rm (Miller 1988)

General Equilibrium approach (Stiglitz 1969)

Firm-level irrelevance does not imply aggregate indeterminacy (e.g. Miller 1977)

ILLUSTRATION: CAPITAL STRUCTURE

MM-Proposition I: A rm’s value is independent of its capital structure

At = 12 , rm 1 and rm 2 yield the same random cashow

At = 0, they have dierent capital structures:

Firm 1 has no debt

Firm 2 has equity and a constant level debt that is risk-free (for simplicity)

At = 0:

Risk-free rate, constant (for simplicity):

Market value of rm ’s debt:

Market value of rm ’s equity:

Market value of rm : = +

Hence, at = 12 

Firm 2’s debtholders receive:  2

Firm 2’s equityholders receive:  2

Step 1: 1 2

Suppose 1  2

At = 0, an investor could:

Short sell a fraction of rm 1’s shares for  1

Keep (1 2 )

Use  2 to buy a fraction of rm 2’s debt and equity as:

 2 = · 2 + · 2

At = 0, the investor would get (1 2 ) 0

At = 12, the investor would get:

 +  2 + · (  2 )=0 for all

Intuition: Arbitrageurs can “unlever” rm 2 by buying equal proportions of its debt and equity so that interest paid and received cancel out

Step 2: 2 1

Suppose 2  1

At = 0, an investor could:

Short sell a fraction of rm 2’s shares for  2

Borrow  2

The total is  2 +  2 =  2

Keep (2 1 )

Use  1 to buy a fraction of rm 1’s shares as:

 1 +  1 = · 1

At = 12 , the investor would receive:  and pay interests ×  2 :

(  2 )  2 +  = 0 for all

Intuition: Arbitrageurs can “lever up” rm 1 by borrowing on their own accounts (“homemade leverage”)

Note: Shareholders are Indi erent to Capital Structure

Consider a rm with no debt: 1 1 + 1 = 1

Assume the rm undertakes a leveraged recapitalization (“recap”):

Borrow an amount 2

Shareholders get a large dividend: = 2

They also retain shares worth 2

Shareholders use to own 100% of the rm

Now, they must share it with the debtholders, i.e. surely 2  1

How can they be indierent?

Without the recap, shareholders’ equity would be worth 1

With the recap, they receive 2 + 2

The equity is worth 2

They receive a dividend = 2

MM says 1 = 2 + 2 Shareholders are indierent to the recap

ILLUSTRATION: DIVIDEND POLICY

Each “period”, the rm:

Invests (Investment Policy)

Raises new capital (Financing Policy)

Retains cash and pays dividends (Payout Policy)

Accounting identity:

Taking investment as given, a change in payout has to be met by a change in nancing

Example: A dividend increase/decrease can be nanced with a new debt issue/retirement

Current and new investors trade among themselves Total claims’ value is unchanged

Competitive investors They break even The current shareholders claims’ value is unchanged

Raises an important question: Why do rms pay dividends?

Good news for MM: The arbitrage proof requires the rms to have the same cashows (largely business driven) but not the same dividends (more discretionary)

USING MM SENSIBLY:

PRACTITIONERS CORNER

MM is not a literal statement about the real world

It obviously leaves important things out

But it gets you to ask the right question:

How is this nancial move going to change the size of the pie?

MM’s most basic message:

Value is created only (i.e. in practice mostly) by operating assets, i.e. on LHS of B/S

A rm’s nancial policy should be (mostly) a means to support the operating policy, not (gen- erally) an end in itself

MM helps you avoid rst-order mistakes

MM vs. WACC Fallacy “Debt is Better Because Debt Is Cheaper Than Equity”

Average rates of return 1926-2000 (in % per year)

 Portfolio Nominal Real Risk Premium (over T-bills) Treasury bills Government bonds Corporate bonds Common stocks (S&P 500) Small-firm common stocks 3.9 0.8 0.0 5.7 2.7 1.8 6.0 3.0 2.1 13.0 9.7 9.1 17.3 13.8 13.4

A rm’s debt is (almost always) safer than its equity Investors demand a lower return for holding debt than for equity (True)

The dierence is signicant: = 6% vs. = 13% expected return

Firms should always use debt nance because they have to give away less returns to investors, i.e. debt is a cheaper source of funds (False)

What is wrong with this argument?

The rm’s Weighted Average Cost of Capital (with no taxes) is:

If  is constant:

  =

    +    +  +   

=

+

X

=1

[ ]

(1 +   )

[ ] and are independent of  (MM Assumption and Prop. I) So is WACC

Riskfree debt (for simplicity) is linear in  because:

= (  )

+  

In practice,     (i.e.  ) increases with 

Intuition: Increasing debt makes existing equity more risky, increasing the expected return investors demand to hold it (NB: Even riskfree debt makes equity riskier, i.e. this is not about default risk)

MM-Proposition II: A rm’s cost of equity increases with its debt-equity ratio

MM vs. Win-Win Fallacy “Debt Is Better Because Some Investors Prefer Debt to Equity”

Clientèles Theory (or Financial Marketing Theory):

Dierent investors prefer dierent consumption streams

They may prefer dierent nancial assets

Financial policy serves these dierent clientèles

Example: All-equity rms might fail to exploit investors’ demands for safe and risky assets. It may be better to issue both debt and equity to allow investors to focus on their preferred asset mix

Intuition for MM:

Investors’ preferences are over consumption, not assets

They (or intermediaries) can slice/dice/combine/retrade the rms’ securities

If investors can undertake the same transactions as rms, at the same prices, they will not pay a premium for rms to undertake them on their behalf No value in nancial marketing

NB: MM do not assume homogeneity but the preference-cashow match need not be done by rms

MM vs. EPS Fallacy “Debt is Better When It Makes EPS Go Up”

EPS can go up (or down) when a rm increases its leverage (True)

Firms should choose their nancial policy to maximize their EPS (False)

EBI(T) is unchanged by a change in capital structure (Recall we assumed no taxes for now)

Creditors receive the safe (or the safest) part of EBIT

Expected EPS might increase but EPS has become riskier

More generally, beware of accounting measures: They often fail to account for risk

MM vs. The “Bird-in-the-Hand” Fallacy

Dividends now are safer than uncertain future payments (True)

They increase rm value (False)

MM show that this theory is awed (“Bird-in-the-Hand” Fallacy)

USING MM SENSIBLY:

MM is a paradigm shift, and the foundation of modern Corporate Finance

Turn MM’s result on its head

If we know what does not matter, we may be able to infer what does

One (or more) of the MM assumptions must be violated

1. Imperfect nancial markets:

Markets are not perfectly competitive?

Transaction costs, short-sale constraints,

Some investors are not fully rational

?

2. Information asymmetry?

3. Financial policy aects cashows (e.g. bankruptcy costs + other ways in which RHS aects LHS)?

4. Taxes?

We are going to relax each assumption in turn

REFERENCES

(s) denotes surveys, books, syntheses, etc.

(s) Grinblatt, Mark, and Sheridan Titman (1998), Financial Markets and Corporate Strategy, Irwin/McGraw-Hill, chapter

13.

Miller, Merton (1977), “Debt and Taxes,” Journal of Finance, 32, 261-276.

(s) Miller, Merton (1988), “The Modigliani-Miller Propositions After Thirty Years,” Journal of Economic Perspective, 2, 99-120. (see the whole issue).

Miller, Merton, and Franco Modigliani (1961), “Dividend Policy, Growth and the Valuation of Shares,” Journal of Business, 34, 411-433.

Modigliani, Franco, and Merton Miller (1958), “The Cost of Capital, Corporation Finance, and the Theory of Invest- ment,” American Economic Review, 48, 261-297.

Stiglitz, Joseph E. (1969), “A Re-Examination of the Modigliani-Miller Theorem,” American Economic Review, 59,

784-793.

Stiglitz, Joseph E. (1974), “On the Irrelevance of Corporate Financial Policy,” American Economic Review, 64, 851-866.

Titman, Sheridan (2002), “The Modigliani and Miller Theorem and the Integration of Financial Markets,” Financial Management, 31, 101-115.

Problem 1 (MM Warm-up)

PROBLEMS

Unless otherwise specied, assume throughout that the Modigliani-Miller conditions hold. ABC Corp. has 2 million shares outstanding and no debt. Each year, it generates (on average) a cash ow of \$96which is paid out to shareholders as

a regular dividend. ABC pays no taxes and its cost of capital is 12%. (Since ABC has no debt, this is also its expected return on equity, which is also referred to as its cost of equity or cost of equity capital).

a) What is ABC’s stock price?

ABC’s CEO plans to borrow \$8and use the proceeds immediately to pay shareholders an exceptional dividend. This level of debt would be riskfree. The riskfree rate is constant and equal to 5%. Answer the following, assuming the transaction (borrowing + exceptional dividend) has already occurred.

b) What is ABC’s new stock price? Compare it to the initial stock price. Explain.

c) Are ABC’s shareholders happy about the CEO’s change in policy?

d) Assume that ABC’s debt is perpetual, i.e., no principal is ever repaid.What is ABC’s annual interest expense? What

is the new average regular annual dividend per share? What is ABC’s new expected return on equity? Compare it to the initial 12% return. Explain.

Problem 2 (MM, The Single-Firm Proof)

The standard proof of the Modigliani-Miller Theorem assumes that for each rm, comparable rms (i.e. in a similar

business) exist that have dierent capital structures. This problem takes you through a proof of the theorem that does not rely on the existence of comparable rms. Consider a rm at = 0 that has (possibly risky) debt with face value maturing at = 1. At = 1, the value of the rm’s assets takes a random value and the rm is liquidated. The riskfree rate is . Assume there are no costs of bankruptcy.

a) Write the value of the rm’s debt and equity as well as the total rm value (debt plus equity) as a function of those

of a risk-free bond and of a call and a put on the rm’s assets.

b) Use an arbitrage argument to prove MM Proposition I (i.e., the irrelevance of capital structure) without resorting to

a comparable rm.

c) Compare this proof to the comparable-rms proof. What are, in your view, its main merits and weaknesses?

Problem 3 (MM, The General Equilibrium Approach)

This problem illustrates a version of MM in a static GE model, and that all agents are indierent to the rms’ capital

structures (in a sense to be claried soon). Consider an economy with a set of rms and a set of individual investors. At = 0, rm has risk-free debt with value , equity with value and total value = + . At = 1, it generates a random cashow . At = 0, individual ’s wealth is invested in risk-free corporate debt and a fraction of rm ’s equity. The risk-free rate is and the gross ris-free rate 1 + . Show that for any given equilibrium, there exists another one with any rm having any other debt-equity ratio but with the value of all rms

ˆ

and the risk-free rate being unchanged. That is, for any equilibrium with , and and for any , there exists an

ˆ

equilibrium with , and . Proceed as follows.

a) Write individual ’s wealth at = 1, , as a function of , , and .

b) Consider an equilibrium with , and . Write the market clearing conditions for rm ’s equity and risk-free debt.

c) Consider a change from to and assume that, indeed, and are unchanged. Show that the are unchanged.

d) Show that the equity markets and the debt market clear.

e) Conclude.

f) Does this imply the irrelevance of the aggregate capital structure, i.e. of the economy-wide debt-equity ratio?

g) Compare this GE version of MM with the more standard arbitrage approach. What are the dierences and similarities?

What are, in your view, the relative strengths and weaknesses of the two approaches?

h) Consider the same model as before but now suppose that, at = 0, the rms can also issue call warrants, i.e. options

to buy new equity, maturing at = 1. Show that for any given equilibrium, there exists another one with any rm issuing any debt/equity and warrants/equity ratios but with the value of all rms and the risk-free rate being unchanged.

ˆ

Problem 4 (MM Proposition II and CAPM)

Assume that the conditions for MM Proposition I are satised and that CAPM holds. MM’s original Proposition II states that as a rm’s cost of equity capital increases linearly with its debt-equity ratio (as long as debt remains risk-free). What is the implicit assumption about the rm for this to hold? Explain.