Modigliani and Miller

Blog 4 - 17/11/2019.

If you’re worried you’ve stumbled across the wrong blog, don’t fear, this isn’t an art blog discussing Amedeo Modigliani the famous Italian painter. This is in fact, a finance blog discussing Franco Modigliani who partnered with Merton Miller in 1958 to tackle the theoretical analysis of the capital structure. Who’d have thought Modigliani would be such a popular name… anyway, I digress. 

The basic assumptions of Modigliani and Miller are that the value of a firm remains constant regardless of their debt levels (Arnold, 2013). Their theory believes that a company’s WACC remains unchanged at all levels of gearing (Watson & Head, 2016). M&M state that the capital structure is irrelevant and that the only way in which a firm can increase shareholder wealth is by making good investment decisions (Arnold, 2013). They began with their theorem that was only true if a number of caveat’s were in play: Markets are completely efficient, there are no associated costs for bankruptcy or agency dynamics, and no taxes. And from this Modigliani and Miller put forward the following proposition: 

They stated that the total market value of a company is totally independent from its capital structure, this is something we’ve briefly touched upon within my introduction, so let’s dig a little deeper. Miller and Modigliani used an arbitrage theory, which states that if goods are the perfect substitutes for each other then they should not sell at different values on the market (Watson & Head, 2016). Applying the arbitrage theory, this would infer that if you were to take two companies that were the same in every way except their capital structure i.e., one financed via equity only, and the other financed purely through debt, their value is still the same.For this example, the formula Modigliani and Miller put forward is: 

VL = Value of levered firm (Financing through debt)

VU = Value of unlevered firm (Financing though equity only)

The simple takeaway from this proposition is that financing through equity or debt remains irrelevant, the WACC level will always remain constant. However, we must remember that this is only true based upon an economy with no tax, which of course is not easily transferable to businesses due to taxation laws. (Kaplan, 2012)

Source: Financial Management. 

In the first graph it illustrates that the WACC remains constant as the financial leverage adjusts so that if debt were to increase then equity would also rise to keep the average cost of capital on a constant, and therefore M&M state that no optimal capital structure, in regards to debt and equity, exists. Portrayed in the second graph is that if the WACC is constant and cash flows remain the same then the value of the firm won’t change. The required return of equity is directly proportional to the increase in gearing. M&M argued ‘There is thus a linear relationship between K_e and gearing, measured as debt/equity’ (Kaplan, 2012). 

A quote defining M&M’s theory that I found on Financial Times I felt was a clear and concise way of encapsulating the clear differences between debt financing and equity financing within their theorem: ‘After all, a factory produces the same amount of product irrespective of how you financed it. You could have borrowed to build it, issued common equity, or had fun with a weird hybrid security like a contingent convertible bond, but the real output of the factory would be the same.’ (Klein, 2015)

However, we must also look into the pitfalls of Modigliani and Miller’s approach, is it transferable? When several factors that they don’t consider within their theory are very much present in a modern economy, can this theorem really be utilised by corporate managers? However, M&M noticed the given flaws in their initial theorem and updated it to consider corporate tax in a later paper published in 1963. Taxation has a measurable benefit on using debt in particular to finance an entity. Debt has the major benefit of being a tax deductible expense which can be offset against profit, and therefore it is required to be included within this updated theorem. 

Source: University lecture presentation.

As you can see the diagram now includes the cost of tax where the cost of debt has to minus the current tax rate to accurately calculate the weighted average cost of capital. So as M&M then concluded within their 1963 paper, gearing reduces the WACC and increases the market value of a company. As you increase the level of gearing you will reduce the WACC due to the tax benefit of debt, which will in turn be a benefit for shareholders as the cost of capital decreases, company values go up and returns to shareholders in dividends will improve. A conclusion from this section of M&M’s updated theory is that companies should be as highly geared as possible (Arnold, 2013). However, this can also be criticised as the company must be able to acknowledge when it’s level of gearing gets too high as excess borrowings can mean that they do not have enough of a safety buffer to enable the company to avoid vulnerability if sudden market changes occur (Arnold, 2013).

If we relate this to a company, Jawbone a privately held tech company is an example of a company that is an interesting relation to Modigliani and Miller’s theory. The company is explained to be bleeding money in the Financial Times and this therefore explains how the company has no corporate tax liability, and so the benefit of debt isn’t apparent.  And so we can assume that perhaps this infers that Modigliani and Miller’s theory is correct, whether Jawbone use a mix of debt or equity is irrelevant due to the benefits of debt not applying to Jawbone as it loses money rapidly. And if we look into the M&M theory in regards to potential bankruptcy then this financial times quote states that ‘High levels of debt to equity (At least for non-financial firms) increase the odds of bankruptcy, which ought to lower the value of the underlying business’ (Klein, 2015). And so if Jawbone were to have a larger percent of its finances funded via debt capital then the company could be in real financial distress nearing bankruptcy due to these higher interest rates associated with the employment of debt capital. This quote from the Financial Times really does infer that the cost of debt and equity is not irrelevant, and that by using one or the other in certain situations can have detrimental impacts on a companies’ value. However, another notable point in regards to M&M’s theory is that it is mainly relatable to private equity groups such as Jawbone. When a private equity firm buys all the shares from a company to ‘take them private’, this therefore means they have complete control of the cost of equity within the firm, often meaning that the debt levels of a private equity firm can often reach up to 70% which wouldn’t be accepted by shareholders if publicly owned. 

In conclusion, Modigliani and Miller’s initial theory from 1958 was useful however there were clearly many flaws due to the unrealistic assumptions it made based on taxes, bankruptcy costs and market efficiency. However, M&M’s updated theory in 1963 that included tax within its theory was much more useful for a finance manager to consider when deciding the mix between debt and equity in financing company operations. Despite M&M’s theory having flaws, a finance manager should still take it into consideration when looking at their financing mix, it’s important to see how this theory relates to current economics of a company and how in the future it could be further developed. 

List of References. 

Arnold, G. (2013). Corporate Value. In Corporate Financial Management(pp. 787 - 791). London: Pearson.

Kaplan. (2012). Theories of gearing.Retrieved from Kaplan: https://kfknowledgebank.kaplan.co.uk/financial-management/corporate-financing/theories-of-gearing#Modigliani_x

Klein, M. C. (2015 , May 21). Jawbone debunks Modigliani-Miller. When’s the crash?Retrieved from Financial Times : https://ftalphaville.ft.com/2015/05/21/2130168/jawbone-debunks-modigliani-miller-whens-the-crash/

Watson, D., & Head, A. (2016). Miller and Modigliani: The Net income approach . In Corporate Finance: Principles and Practice(pp. 299 - 301). London: Pearson.