Overview:
• The ModiglianiMiller Theorem
• Illustration:
— Capital Structure
— Dividend Policy
• Using MM sensibly:
— Practitioners
— Academics
D. Gromb
The ModiglianiMiller Theorem
1
FINANCIAL POLICY
• Investment policy: Business decisions
— CAPX
— R&D
— Etc.
• Financial policy:
— Financing decisions: Internal funds (i.e. cash reserves), debt, trade credit, equity, etc.
— Capital structure
— Longterm vs. shortterm debt
— Floating vs. ﬁxed interest rate debt
— Debt’s currency denomination
— Dividend, share repurchases, etc.
— Risk management (e.g. interest rate hedging)
— Etc.
D. Gromb
The ModiglianiMiller Theorem
2
MODIGLIANIMILLER IRRELEVANCE THEOREM
Modigliani and Miller (1958, 1961)
ModiglianiMiller Theorem:
Under some assumptions, a ﬁrm’s value is independent of its ﬁnancial policy
Assumptions:
1. Perfect ﬁnancial markets:
• Competitive: Individuals and ﬁrms are pricetakers
• Frictionless: No transaction costs, etc.
• All agents are rational
2. All agents have the same information
3. A ﬁrm’s cashﬂows do not depend on its ﬁnancial policy (e.g. no bankruptcy costs)
4. No taxes
• ⇒ No point studying corporate ﬁnancial policy
D. Gromb
The ModiglianiMiller Theorem
3
• Value additivity:
Proof
— Arbitrage opportunity: Ability to make a riskfree proﬁt by trading ﬁnancial claims
— Equilibrium ⇒ No arbitrage opportunity ⇒ If and are risky cashﬂow streams
• Firm value:
( + ) = () + ( )
— By deﬁnition, a ﬁrm’s value is the sum of the values of all its ﬁnancial claims
— The cashﬂows all its claims receive must add up to the total cashﬂow its assets generate
— Value additivity ⇒ The ﬁrm’s value must equal that of the assets’ cashﬂow stream
— Intuition: Economic equivalent of the accounting identity between assets and liabilities
• Consider identical ﬁrms with diﬀerent ﬁnancial policies:
— Same assets ⇒ Same cashﬂow streams ⇒ Same ﬁrm values
D. Gromb
The ModiglianiMiller Theorem
4
The original propositions:
Remarks
• MMProposition I (MM 1958): A ﬁrm’s total market value is independent of its capital structure
• MMProposition II (MM 1958): A ﬁrm’s cost of equity increases with its debtequity ratio
• Dividend Irrelevance (MM 1961): A ﬁrm’s total market value is independent of its dividend policy
• Investor Indiﬀerence (Stiglitz 1969): Individual investors are indiﬀerent to all ﬁrms’ ﬁnancial policies
Diﬀerent approaches:
• MM’s proof requires two identical ﬁrms
• Alternatives:
— Arbitrage approach with a single ﬁrm (Miller 1988)
— General Equilibrium approach (Stiglitz 1969)
• Firmlevel irrelevance does not imply aggregate indeterminacy (e.g. Miller 1977)
D. Gromb
The ModiglianiMiller Theorem
5
ILLUSTRATION: CAPITAL STRUCTURE
MMProposition I: A ﬁrm’s value is independent of its capital structure
• At = 1 2 , ﬁrm 1 and ﬁrm 2 yield the same random cashﬂow _{}
• At = 0, they have diﬀerent capital structures:
— Firm 1 has no debt
— Firm 2 has equity and a constant level debt that is riskfree (for simplicity)
• At = 0:
— Riskfree rate, constant (for simplicity):
— Market value of ﬁrm ’s debt: _{}
— Market value of ﬁrm ’s equity: _{}
— Market value of ﬁrm : _{} = _{} + _{}
• Hence, at = 1 2
— Firm 1’s equityholders receive: _{}
— Firm 2’s debtholders receive: _{2}
— Firm 2’s equityholders receive: _{} − _{2}
D. Gromb
The ModiglianiMiller Theorem
6
Step 1: _{1} ≤ _{2}
• Suppose _{1} _{2}
• At = 0, an investor could:
— Short sell a fraction of ﬁrm 1’s shares for _{1}
— Keep ( _{1} − _{2} )
— Use _{2} to buy a fraction of ﬁrm 2’s debt and equity as:
_{2} = · _{2} + · _{2}
• At = 0, the investor would get ( _{1} − _{2} ) 0
• At = 1 2, the investor would get:
− _{} + _{2} + · ( _{} − _{2} )=0 for all _{}
• ⇒ An arbitrage opportunity exists ⇒ Contradiction
• Intuition: Arbitrageurs can “unlever” ﬁrm 2 by buying equal proportions of its debt and equity so that interest paid and received cancel out
D. Gromb
The ModiglianiMiller Theorem
7
Step 2: _{2} ≤ _{1}
• Suppose _{2} _{1}
• At = 0, an investor could:
— Short sell a fraction of ﬁrm 2’s shares for _{2}
— Borrow _{2}
— The total is _{2} + _{2} = _{2}
— Keep ( _{2} − _{1} )
— Use _{1} to buy a fraction of ﬁrm 1’s shares as:
_{1} + _{1} = · _{1}
• At = 1 2 , the investor would receive: _{} and pay interests × _{2} :
− ( _{} − _{2} ) − _{2} + _{} = 0 for all _{}
• ⇒ An arbitrage opportunity exists ⇒ Contradiction
• Intuition: Arbitrageurs can “lever up” ﬁrm 1 by borrowing on their own accounts (“homemade leverage”)
D. Gromb
The ModiglianiMiller Theorem
8
Note: Shareholders are Indi ﬀerent to Capital Structure
• Consider a ﬁrm with no debt: _{1} ≡ _{1} + _{1} = _{1}
• Assume the ﬁrm 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 ﬁrm
• Now, they must share it with the debtholders, i.e. surely _{2} _{1}
• How can they be indiﬀerent?
• 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 indiﬀerent to the recap
D. Gromb
The ModiglianiMiller Theorem
9
ILLUSTRATION: DIVIDEND POLICY
• Each “period”, the ﬁrm:
— 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 ﬁnancing
— Example: A dividend increase/decrease can be ﬁnanced 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 ﬁrms pay dividends?
• Good news for MM: The arbitrage proof requires the ﬁrms to have the same cashﬂows (largely business driven) but not the same dividends (more discretionary)
D. Gromb
The ModiglianiMiller Theorem
10
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 ﬁnancial 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 ﬁrm’s ﬁnancial policy should be (mostly) a means to support the operating policy, not (gen erally) an end in itself
• MM helps you avoid ﬁrstorder mistakes
D. Gromb
The ModiglianiMiller Theorem
11
MM vs. WACC Fallacy “Debt is Better Because Debt Is Cheaper Than Equity”
Average rates of return 19262000 (in % per year)
Portfolio 
Nominal 
Real 
Risk Premium (over Tbills) 
Treasury bills Government bonds Corporate bonds Common stocks (S&P 500) Smallfirm 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 ﬁrm’s debt is (almost always) safer than its equity ⇒ Investors demand a lower return for holding debt than for equity (True)
• The diﬀerence is signiﬁcant: _{} = 6% vs. _{} = 13% expected return
• Firms should always use debt ﬁnance 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?
D. Gromb
The ModiglianiMiller Theorem
12
• The ﬁrm’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)
MMProposition II: A ﬁrm’s cost of equity increases with its debtequity ratio
D. Gromb
The ModiglianiMiller Theorem
13
MM vs. WinWin Fallacy “Debt Is Better Because Some Investors Prefer Debt to Equity”
Clientèles Theory (or Financial Marketing Theory):
• Diﬀerent investors prefer diﬀerent consumption streams
• ⇒ They may prefer diﬀerent ﬁnancial assets
• ⇒ Financial policy serves these diﬀerent clientèles
• Example: Allequity ﬁrms 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 ﬁrms’ securities
• If investors can undertake the same transactions as ﬁrms, at the same prices, they will not pay a premium for ﬁrms to undertake them on their behalf ⇒ No value in ﬁnancial marketing
• NB: MM do not assume homogeneity but the preferencecashﬂow match need not be done by ﬁrms
D. Gromb
The ModiglianiMiller Theorem
14
MM vs. EPS Fallacy “Debt is Better When It Makes EPS Go Up”
• EPS can go up (or down) when a ﬁrm increases its leverage (True)
• Firms should choose their ﬁnancial 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
D. Gromb
The ModiglianiMiller Theorem
15
MM vs. The “BirdintheHand” Fallacy
• Dividends now are safer than uncertain future payments (True)
• ⇒ They increase ﬁrm value (False)
• MM show that this theory is ﬂawed (“BirdintheHand” Fallacy)
D. Gromb
The ModiglianiMiller Theorem
16
USING MM SENSIBLY:
ACADEMICS’ CORNER
• 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 ﬁnancial markets:
• Markets are not perfectly competitive?
• Transaction costs, shortsale constraints,
• Some investors are not fully rational
?
2. Information asymmetry?
3. Financial policy aﬀects cashﬂows (e.g. bankruptcy costs + other ways in which RHS aﬀects LHS)?
4. Taxes?
• We are going to relax each assumption in turn
D. Gromb
The ModiglianiMiller Theorem
17
REFERENCES
(s) denotes surveys, books, syntheses, etc.
(s) Grinblatt, Mark, and Sheridan Titman (1998), Financial Markets and Corporate Strategy, Irwin/McGrawHill, chapter
13.
Miller, Merton (1977), “Debt and Taxes,” Journal of Finance, 32, 261276.
(s) Miller, Merton (1988), “The ModiglianiMiller Propositions After Thirty Years,” Journal of Economic Perspective, 2, 99120. (see the whole issue).
Miller, Merton, and Franco Modigliani (1961), “Dividend Policy, Growth and the Valuation of Shares,” Journal of Business, 34, 411433.
Modigliani, Franco, and Merton Miller (1958), “The Cost of Capital, Corporation Finance, and the Theory of Invest ment,” American Economic Review, 48, 261297.
Stiglitz, Joseph E. (1969), “A ReExamination of the ModiglianiMiller Theorem,” American Economic Review, 59,
784793.
Stiglitz, Joseph E. (1974), “On the Irrelevance of Corporate Financial Policy,” American Economic Review, 64, 851866.
Titman, Sheridan (2002), “The Modigliani and Miller Theorem and the Integration of Financial Markets,” Financial Management, 31, 101115.
D. Gromb
The ModiglianiMiller Theorem
18
Problem 1 (MM Warmup)
PROBLEMS
Unless otherwise speciﬁed, assume throughout that the ModiglianiMiller conditions hold. ABC Corp. has 2 million shares outstanding and no debt. Each year, it generates (on average) a cash ﬂow of $96 which 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 $8 and 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 SingleFirm Proof)
The standard proof of the ModiglianiMiller Theorem assumes that for each ﬁrm, comparable ﬁrms (i.e. in a similar
business) exist that have diﬀerent capital structures. This problem takes you through a proof of the theorem that does not rely on the existence of comparable ﬁrms. Consider a ﬁrm at = 0 that has (possibly risky) debt with face value maturing at = 1. At = 1, the value of the ﬁrm’s assets takes a random value and the ﬁrm is liquidated. The riskfree rate is . Assume there are no costs of bankruptcy.
a) Write the value of the ﬁrm’s debt and equity as well as the total ﬁrm value (debt plus equity) as a function of those
of a riskfree bond and of a call and a put on the ﬁrm’s assets.
D. Gromb
The ModiglianiMiller Theorem
19
b) Use an arbitrage argument to prove MM Proposition I (i.e., the irrelevance of capital structure) without resorting to
a comparable ﬁrm.
c) Compare this proof to the comparableﬁrms 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 indiﬀerent to the ﬁrms’ capital
structures (in a sense to be clariﬁed soon). Consider an economy with a set of ﬁrms and a set of individual investors. At = 0, ﬁrm ∈ has riskfree debt with value _{} , equity with value _{} and total value _{} = _{} + _{} . At = 1, it generates a random cashﬂow _{} . At = 0, individual ∈ ’s wealth ^{} is invested in ^{} riskfree corporate debt and a fraction ^{} of ﬁrm ’s equity. The riskfree rate is and the gross risfree rate ≡ 1 + . Show that for any given equilibrium, there exists another one with any ﬁrm having any other debtequity ratio but with the value of all ﬁrms
ˆ
and the riskfree 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 ﬁrm ’s equity and riskfree 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 economywide debtequity ratio?
g) Compare this GE version of MM with the more standard arbitrage approach. What are the diﬀerences 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 ﬁrms 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 ﬁrm issuing any debt/equity and warrants/equity ratios but with the value of all ﬁrms and the riskfree rate being unchanged.
ˆ
Problem 4 (MM Proposition II and CAPM)
D. Gromb
The ModiglianiMiller Theorem
20
Assume that the conditions for MM Proposition I are satisﬁed and that CAPM holds. MM’s original Proposition II states that as a ﬁrm’s cost of equity capital increases linearly with its debtequity ratio (as long as debt remains riskfree). What is the implicit assumption about the ﬁrm for this to hold? Explain.
D. Gromb
The ModiglianiMiller Theorem
21
Molto più che documenti.
Scopri tutto ciò che Scribd ha da offrire, inclusi libri e audiolibri dei maggiori editori.
Annulla in qualsiasi momento.