THE MODIGLIANI-MILLER THEOREM

Overview:
The Modigliani-Miller Theorem
Illustration:
Capital Structure
Dividend Policy
Using MM sensibly:
Practitioners
Academics
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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
Long-term vs. short-term debt
Floating vs. xed interest rate debt
Debts currency denomination
Dividend, share repurchases, etc.
Risk management (e.g. interest rate hedging)
Etc.
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MODIGLIANI-MILLER IRRELEVANCE THEOREM
Modigliani and Miller (1958, 1961)
Modigliani-Miller Theorem:
Under some assumptions, a rms 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 rms cashows do not depend on its nancial policy (e.g. no bankruptcy costs)
4. No taxes
No point studying corporate nancial policy
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Proof
Value additivity:
Arbitrage opportunity: Ability to make a risk-free prot by trading nancial claims
Equilibrium No arbitrage opportunity If and 1 are risky cashow streams
\ (+1) = \ () + \ (1)
Firm value:
By denition, a rms 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 rms 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
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Remarks
The original propositions:
MM-Proposition I (MM 1958): A rms total market value is independent of its capital structure
MM-Proposition II (MM 1958): A rms cost of equity increases with its debt-equity ratio
Dividend Irrelevance (MM 1961): A rms total market value is independent of its dividend policy
Investor Indierence (Stiglitz 1969): Individual investors are indierent to all rms nancial policies
Dierent approaches:
MMs 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)
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ILLUSTRATION: CAPITAL STRUCTURE
MM-Proposition I: A rms value is independent of its capital structure
At t = 1. 2. ..., rm 1 and rm 2 yield the same random cashow A
t
At t = 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 t = 0:
Risk-free rate, constant (for simplicity): :
Market value of rm is debt: 1
i
Market value of rm is equity: 1
i
Market value of rm i: \
i
= 1
i
+1
i
Hence, at t = 1. 2. ...
Firm 1s equityholders receive: A
t
Firm 2s debtholders receive: :1
2
Firm 2s equityholders receive: A
t
:1
2
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Step 1: \
1
\
2
Suppose \
1
\
2
At t = 0, an investor could:
Short sell a fraction c of rm 1s shares for c\
1
Keep c(\
1
\
2
)
Use c\
2
to buy a fraction c of rm 2s debt and equity as:
c\
2
= c 1
2
+c 1
2
At t = 0, the investor would get c(\
1
\
2
) 0
At t = 1. 2..., the investor would get:
cA
t
+c:1
2
+c (A
t
:1
2
) = 0 for all A
t
An arbitrage opportunity exists Contradiction
Intuition: Arbitrageurs can unlever rm 2 by buying equal proportions of its debt and equity so
that interest paid and received cancel out
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Step 2: \
2
\
1
Suppose \
2
\
1
At t = 0, an investor could:
Short sell a fraction c of rm 2s shares for c1
2
Borrow c1
2
The total is c1
2
+ c1
2
= c\
2
Keep c(\
2
\
1
)
Use c\
1
to buy a fraction c of rm 1s shares as:
c1
1
+c1
1
= c \
1
At t = 1. 2. ..., the investor would receive: cA
t
and pay interests : c1
2
:
c(A
t
:1
2
) :c1
2
+ cA
t
= 0 for all A
t
An arbitrage opportunity exists Contradiction
Intuition: Arbitrageurs can lever up rm 1 by borrowing on their own accounts (homemade
leverage)
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Note: Shareholders are Indierent to Capital Structure
Consider a rm with no debt: \
1
1
1
+ 1
1
= 1
1
Assume the rm undertakes a leveraged recapitalization (recap):
Borrow an amount 1
2
Shareholders get a large dividend: d = 1
2
They also retain shares worth 1
2
Shareholders use to own 100% of the rm
Now, they must share it with the debtholders, i.e. surely 1
2
< 1
1
How can they be indierent?
Without the recap, shareholders equity would be worth 1
1
With the recap, they receive 1
2
+1
2
The equity is worth 1
2
They receive a dividend d = 1
2
MM says 1
1
= 1
2
+1
2
Shareholders are indierent to the recap
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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)
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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?
MMs most basic message:
Value is created only (i.e. in practice mostly) by operating assets, i.e. on LHS of B/S
A rms 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
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MM vs. WACC Fallacy
Debt is Better Because Debt Is Cheaper Than Equity
Portfolio Nominal Real Risk Premium (over T-bills)
Treasury bills 3.9 0.8 0.0
Government bonds 5.7 2.7 1.8
Corporate bonds 6.0 3.0 2.1
Common stocks (S&P 500) 13.0 9.7 9.1
Small-firm common stocks 17.3 13.8 13.4
Average rates of return 1926-2000 (in % per year)
A rms debt is (almost always) safer than its equity Investors demand a lower return for holding
debt than for equity (True)
The dierence is signicant: :
1
= 6% vs. :
1
= 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?
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The rms Weighted Average Cost of Capital (with no taxes) is:
\CC =
1
1+1
:
1
+
1
1+ 1
:
1
If 1,1 is constant:
\ =
+
X
t=1
1 [A
t
]
(1 +\CC)
t
1[A] and \ are independent of 1,1 (MM Assumption and Prop. I) So is WACC
Riskfree debt (for simplicity) :
1
is linear in 1,1 because:
:
1
= (\CC :)
1
1
+\CC
In practice, \CC : (i.e. :
1
:) :
1
increases with 1,1
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 rms cost of equity increases with its debt-equity ratio
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MM vs. Win-Win Fallacy
Debt Is Better Because Some Investors Prefer Debt to Equity
Clientles Theory (or Financial Marketing Theory):
Dierent investors prefer dierent consumption streams
They may prefer dierent nancial assets
Financial policy serves these dierent clientles
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
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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
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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)
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USING MM SENSIBLY:
ACADEMICS CORNER
MM is a paradigm shift, and the foundation of modern Corporate Finance
Turn MMs 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
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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.
D. Gromb The Modigliani-Miller Theorem 18
PROBLEMS
Problem 1 (MM Warm-up)
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 $9.6: 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 ABCs stock price?
ABCs 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 ABCs new stock price? Compare it to the initial stock price. Explain.
c) Are ABCs shareholders happy about the CEOs change in policy?
d) Assume that ABCs debt is perpetual, i.e., no principal is ever repaid.What is ABCs annual interest expense? What
is the new average regular annual dividend per share? What is ABCs 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 t = 0 that has (possibly risky) debt with face value 1 maturing at t = 1. At t = 1, the value of the
rms assets takes a random value A and the rm is liquidated. The riskfree rate is :. Assume there are no costs of
bankruptcy.
a) Write the value of the rms 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 rms assets.
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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 1 of rms and a set J of individual investors.
At t = 0, rm i 1 has risk-free debt with value 1

, equity with value 1

and total value \

= 1

+ 1

. At t = 1, it
generates a random cashow A

. At t = 0, individual , Js wealth n

is invested in 1

risk-free corporate debt and

a fraction c

of rm is equity. The risk-free rate is : and the gross ris-free rate 1 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
and the risk-free rate being unchanged. That is, for any equilibrium with 1

, \

and : and for any

1

, there exists an
equilibrium with

1

, \

and :. Proceed as follows.

a) Write individual ,s wealth at t = 1,

, as a function of n

, c

, \

and A

.
b) Consider an equilibrium with 1

, \

and :. Write the market clearing conditions for rm is equity and risk-free debt.
c) Consider a change from 1

to

1

and assume that, indeed, \

and : are unchanged. Show that the c

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 t = 0, the rms can also issue call warrants, i.e. options
to buy new equity, maturing at t = 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.
Problem 4 (MM Proposition II and CAPM)
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Assume that the conditions for MM Proposition I are satised and that CAPM holds. MMs original Proposition II states
that as a rms 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.
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