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Miller and Modigliani

Propositions
Lecture Note 6

FIN 751 T. Barkley

LN6.1

Miller and Modigliani


Giants in finance for their work
Nobel Prize Winners
Markowitz, Miller and Sharpe (1990) for
pioneering work in the theory of financial
economics
Modigliani (1985) for his pioneering
analyses of saving and of financial
markets
FIN 751 T. Barkley Miller and Modigliani

LN6.2

Modigliani-Miller Theorem
Provides conditions under which a firms
financial decisions do not affect its value
Comprises four distinct results from a series of
papers (1958, 1961, 1963)
1. Under certain conditions, a firms debt-equity
ratio does not affect its market value
2. A firms leverage has no effect on its weighted
average cost of capital
3. A firms market value is independent of its
dividend policy
4. Equity-holders are indifferent about the firms
financial policy
FIN 751 T. Barkley Miller and Modigliani

LN6.3

Modigliani (1980) Explains


with well-functioning markets (and neutral
taxes) and rational investors, who can undo
the corporate financial structure by holding
positive or negative amounts of debt, the
market value of the firm debt plus equity
depends only on the income stream generated
by its assets. It follows, in particular, that the
value of the firm should not be affected by the
share of debt in its financial structure or by
what will be done with the returns paid out
as dividends or reinvested (profitably).
FIN 751 T. Barkley Miller and Modigliani

LN6.4

Miller (1991) Uses an Analogy


Think of the firm as a gigantic tub of whole milk. The
farmer can sell the whole milk as is. Or he can separate
out the cream, and sell it at a considerably higher price
than the whole milk would bring. (Thats the analog of a
firm selling low-yield and hence high-priced debt
securities.) But, of course, what the farmer would have
left would be skim milk with low butterfat content and that
would sell for much less than whole milk. That
corresponds to the levered equity. The Modigliani-Miller
proposition says that if there were no costs of separation
(and, of course, no government dairy support programs),
the cream plus the skim milk would bring the same price
as the whole milk.

FIN 751 T. Barkley Miller and Modigliani

LN6.5

Two Fundamental Contributions


Formal use of a no-arbitrage
argument
Law of One Price
Law of Conservation of Value

Irrelevance fails when assumptions are


relaxed

FIN 751 T. Barkley Miller and Modigliani

LN6.6

The Assumptions Made


No taxes
No capital market frictions
No transaction costs
No bankruptcy (financial distress) costs
No asset trade restrictions

No asymmetric information
Efficient markets
These last two assumptions imply
Symmetric access to credit markets for firms and
investors

They can borrow or lend at the same rate

Firms dont withhold information from capital markets


FIN 751 T. Barkley Miller and Modigliani

LN6.7

Key Result
With perfect markets investors can
costlessly replicate a firms financial
actions
This allows investors to undo firm
decisions if they so wish hence:
Capital structure is irrelevant!
(Debt policy does not matter)

Distribution of earnings is irrelevant!


(Dividend/payout policy does not matter)
FIN 751 T. Barkley Miller and Modigliani

LN6.8

Capital Structure
Important Questions to Ask

FIN 751 T. Barkley

LN6.9

Capital Structure
Decisions about capital structure involve shuffling
items on the liabilities side of the balance sheet:
How should firms choose between debt and equity in
making optimal financing decisions?

Financing Decisions Capital Structure


Decisions
Two kinds of capital structure decisions
Capital Raising

Issuing/redeeming debt, issuing/repurchasing equity,


exchange offers

Capital Disbursement
Increasing/decreasing payouts (with cash or stock)

FIN 751 T. Barkley Miller and Modigliani

LN6.10

Some Questions to Consider


Is there a right mix of debt and equity? Does it matter?
What are the costs of the sources of financing? WACC?
Is there an optimal mix of debt and equity that minimizes
WACC?
Can value be created for investors through financing
decisions?
Are costs of debt and equity affected by amounts of each
other?
Do financing decisions affect the real side of the
balance sheet?
Do markets read signals into financing decisions?

FIN 751 T. Barkley Miller and Modigliani

LN6.11

The Structure of Financing


Decisions
Investment decisions cannot be separated
from financing decisions
Assets = Debt + Equity + Profits Dividends
(1)

(2)

(3)

(4)

(5)

(1) and (4) reflect the results of


investment/operating/competitive strategies
(2), (3) and (5) reflect financing (capital
structure) choices
FIN 751 T. Barkley Miller and Modigliani

LN6.12

The Goal of Capital Structure


Decisions
A firms market value balance sheet
Assets

Liabilities

Tangible assets
Intangible assets

Debt (D)
Equity (E)

Firm value (V)

Can V be increased by changing D and E?


FIN 751 T. Barkley Miller and Modigliani

LN6.13

The Goal of Capital Structure


Decisions (cont)
1. Increase V by altering the mix of D and E
2. Increase E by transferring value from D

The first alternative is the same as


increasing firm value by minimizing
the weighted average cost of capital
(WACC)
The second alternative is an agency
problem
FIN 751 T. Barkley Miller and Modigliani

LN6.14

Miller and Modigliani


What Do We Learn from Them?

FIN 751 T. Barkley

LN6.15

Modigliani-Miller Theorem
Often called the capital structure
irrelevance principle
Consider two firms which are identical except
for their financial structures
The first firm (U) is unlevered financed by
equity only
The second firm (L) is levered financed
partly by debt and partly by equity
The Modigliani-Miller Theorem states that the
value of the two firms is the same
FIN 751 T. Barkley Miller and Modigliani

LN6.16

Without Taxes
Proposition I
VU = V L
Why?
Suppose an investor is considering buying shares in
one of the two firms
Instead of buying the shares of firm L, the investor
can purchase 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
Hence the price of L must be the same as the price of
U minus the money borrowed B (the value of Ls debt)

FIN 751 T. Barkley Miller and Modigliani

LN6.17

Miller Gives Another Explanation


I have a simple explanation [for the first
Modigliani-Miller proposition]. Its after the ball
game, and the pizza man comes up to Yogi
Berra and he says, Yogi, how do you want me
to cut this pizza, into quarters? Yogi says, No,
cut it into eight pieces, Im feeling hungry
tonight. Now when I tell that story the usual
reaction is, And you mean to say that they
gave you a [Nobel] prize for that?
M. H. Miller, from his testimony in Glendale Federal Banks
lawsuit against the U.S. government, December 1997
FIN 751 T. Barkley Miller and Modigliani

LN6.18

Without Taxes
Proposition II
rE = rA + (D/E)(rA rD)

rE is the required rate of return on equity (or cost of equity)


rA is the cost of capital for an all-equity firm
rD is the required rate of return on borrowings (or cost of debt)
D/E is the debt-to-equity ratio

This proposition states that the cost of equity is a linear


function of the firms debt-to-equity ratio, as long as the
debt is risk-free
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

FIN 751 T. Barkley Miller and Modigliani

LN6.19

Proposition II with Risky Debt


As leverage (D/E) increases, the WACC
stays constant

FIN 751 T. Barkley Miller and Modigliani

LN6.20

Without Taxes
The propositions are true under the MillerModigliani assumptions
BUT
In the real world none of these conditions are met
so why study this?

If capital structure matters, then it must be


because one (or more) of the assumptions is
violated
The Miller-Modigliani Theorem suggests where to
look for determinants of optimal capital structure
and how those factors might affect it

FIN 751 T. Barkley Miller and Modigliani

LN6.21

With Taxes
Proposition I
VL = VU + TcD
VU is the value of a levered firm
VU is the value of an unlevered firm
TcD is the tax rate the value of debt

There are advantages for firms to be levered,


since corporations can deduct interest payments
Thus, leverage lowers tax payments
However, dividend payments are non-deductible
FIN 751 T. Barkley Miller and Modigliani

LN6.22

With Taxes
Proposition II
rE = rA + (D/E)(rA rD)(1 Tc)
rE is the required rate of return on equity (or cost of equity)
rA is the cost of capital for an all-equity firm
rD is the required rate of return on borrowings (or cost of
debt)
D/E is the debt-to-equity ratio
Tc is the corporate tax rate

This proposition states (as before) that the cost of


equity rises with leverage because the risk to equity
rises
The formula, however, has implications for the
difference with the WACC
FIN 751 T. Barkley Miller and Modigliani

LN6.23

Summary
Capital structure decisions are qualitative
decisions
The basic insight from MM is that firms should
not worry too much about their capital
structure instead, firms should focus on
value-creation from the assets side of the
balance sheet
However, taxes, financial distress, asset types,
agency problems and signaling issues play
significant roles in the capital structure
decision
FIN 751 T. Barkley Miller and Modigliani

LN6.24

Summary (cont)
There may be some optimal capital
structure that results from trade-offs
between these factors, but it is difficult
to discern
Also to be kept in mind are issues of
control, flexibility, financial slack,
transactions costs, timing, etc.

FIN 751 T. Barkley Miller and Modigliani

LN6.25

The Last Word


As Miller (1988) said

Showing what doesnt matter can also


show, by implication, what does.

FIN 751 T. Barkley Miller and Modigliani

LN6.26

References
Modigliani, F., and M. H. Miller, 1958, The Cost of Capital,
Corporate Finance and the Theory of Investment, American
Economic Review, 53, 433-43.
Miller, M. H., and F. Modigliani, 1961, Dividend Policy, Growth
and the Valuation of Shares, Journal of Business, 34, 411-33.
Modigliani, F., and M. H. Miller, 1963, Corporate Income Taxes
and the Cost of Capital: A Correction, American Economic
Review, 53, 433-43
Modigliani, F., 1980, Introduction in The Collected Papers of
Franco Modigliani, Vol. 3, pp. xi-xix (MIT Press, Cambridge,
MA).
Miller, M. H., 1988, The Modigliani-Miller Proposition after
Thirty Years, Journal of Economic Perspectives, 2, 99-120.
Miller, M. H., 1991, Financial Innovations and Market Volatility
(Blackwell Publishers, Cambridge, MA).
FIN 751 T. Barkley Miller and Modigliani

LN6.27