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“The Value of the firm & M. M. theory”- Dividend perspective

Introduction

Miller and Modigliani’s (1958) irrelevance theorem is one of the important and puzzling issues in modern corporate finance theory, which has challenged the traditional view that an optimum leverage exists. The main source of the puzzle stems from the fact that financial research don’t seem to explain the firm financing behavior as we attempt to reconcile the MM theory with the evidence(Myers 1984, Gordon and Chamberlin1994, Rajan and Zingales1995). The MM theorem has shown that under a perfect market hypothesis the market value of any firm is independent of its capital structure (Stulz 2006). This fundamental proposition explicitly indicates that the aptitude of investors to engage in personal or “homemade” leverage is sufficient to ensure that corporate leverage in itself cannot modify the total market value of the firm. In other words, the theorem provides conditions under which arbitrage by individuals keeps the value of the firm depending only on cash flow generated by the investment policy. Following the seminal paper of MM (1958), most theories have been put forward in corporate finance to reconcile the shortcomings of the irrelevance theorem with variables that explain the firm’s choice of capital structure. According to the previous debate, criticism against this theorem can be grouped in two types of arguments: on the one hand, there are papers which deal with the limitations of the arbitrage conditions; on the other hand, there are studies which analyze the effect of market imperfections on the firm’s choice of capital structure. Despite the importance of these investigations, we note that all of the limitations deal with the explicit assumptions used by MM, but none deals with the critiques of the MM’s implicit assumptions. More recently, DeAngelo and DeAngelo (2006, DD hereafter) have challenged MM’s irrelevance dividend policy. Dealing with this alternative of earnings as fully distributed, these authors have shown the irrelevance of the MM dividend irrelevance theorem when MM’s assumptions are relaxed to allow retention (note 2). According to DD(2006), the MM’s irrelevance theorem forces firms to choose only among dividend policies that distribute the full present value of free cash flow(FCF) to shareholders. Distributions below the totality of earnings are ruled out by the implicit hypothesis. Dealing with this problem of fully-distributed earnings, MM(1958) used the same hypothesis in the development of the irrelevance of capital structure. As pointed by the authors “….as will become clear later, as long as management is presumed to be acting in the best interests of the stockholders, retained earnings can be regarded as equivalent to a fully subscribed, pre-emptive issue of common stock. Hence, for present purposes, the division of the stream between cash dividends and retained earnings in any period is a mere detail.” MM, 1958 p266.

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“The Value of the firm & M. M. theory”- Dividend perspective

About Merton Howard Miller

Merton Howard Miller (May 16, 1923 – June 3, 2000) was the co-author of the Modigliani-Miller theorem which proposed the irrelevance of debt-equity structure. Miller spent most of his academic career at the University Of Chicago Booth School Of Business.

Early years

Miller was born Jewish, in Boston, Massachusetts to Joel and Sylvia Miller, an attorney and housewife. He worked during World War II as an economist in the division of tax research of the Treasury Department, and received a Ph.D. in economics from Johns Hopkins University, 1952. His first academic appointment after receiving his doctorate was Visiting Assistant Lecturer at the London School of Economics.

Career

In 1958, at Carnegie Institute of Technology (now Carnegie Mellon University), he collaborated with his colleague Franco Modigliani there to write a paper on “The Cost of Capital, Corporate Finance and the Theory of Investment.” This paper urged a fundamental objection to the traditional view of corporate finance, according to which a corporation can reduce its cost of capital by finding the right debt-to-equity ratio. According to the Modigliani-Miller theorem, on the other hand, there is no right ratio, so corporate managers should seek to minimize tax liability and maximize corporate net wealth, letting the debt ratio chips fall where they will.

The way in which they arrived at this conclusion made use of the "no arbitrage" argument, i.e. the premise that any state of affairs that will allow traders of any market instrument to create a riskless money machine will almost immediately disappear. They set the pattern for many arguments based on that premise in subsequent years.

Miller wrote or co-authored eight books. He became a fellow of the Econometric Society in 1975 and was president of the American Finance Association in 1976. He was on the faculty of the University Of Chicago Graduate School Of Business from 1961 until his retirement in 1993, although he continued teaching at the school for several more years. His works formed the basis of the "Modigliani-Miller Financial Theory".

He served as a public director on the Chicago Board of Trade 1983-85 and the Chicago Mercantile Exchange from 1990 until his death in Chicago on June 3, 2000.

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“The Value of the firm & M. M. theory”- Dividend perspective

Personal life

Miller was married to Eleanor Miller, who died in 1969. He was survived by his second wife, Katherine Miller, and by three children from his first marriage and two grandsons’ three children by his first marriage: Pamela (1952), Margot (1955), and Louise (1958).

About Franco Modigliani

Franco Modigliani (June 18, 1918 – September 25, 2003) was an Italian economist at the MIT Sloan School of Management and MIT Department of Economics,

Life and career

Born in Rome, Italy, he left Italy in 1939 because of his Jewish origin and antifascist views. He first went to Paris with the family of his then-girlfriend, Serena, whom he married in 1939, and then to the United States. From 1942 to 1944, he taught at Columbia University and Bard College as an instructor in economics and statistics. In 1944, he obtained his D. Soc. Sci. from the New School for Social Research working under Jacob Marschak. In 1946, he became a naturalized citizen of the United States, and in 1948, he joined the University of Illinois at Urbana-Champaign faculty.

When he was a professor at the Graduate School of Industrial Administration of Carnegie Mellon University in the 1950s and early 1960s, Modigliani made two path-breaking contributions to economic science. Along with Merton Miller, he formulated the important Modigliani-Miller theorem in corporate finance. This theorem demonstrated that under certain assumptions, the value of a firm is not affected by whether it is financed by equity (selling shares) or debt (borrowing money). In 1962, he joined the faculty at MIT, achieving distinction as an Institute Professor, where he stayed until his death. In 1985 he received MIT's James R. Killian Faculty Achievement Award.[1]

Modigliani also co-authored the textbooks, "Foundations of Financial Markets and Institutions" and "Capital Markets: Institutions and Instruments" with Frank J. Fabozzi of Management. In the 1990s he teamed up with Francis Vitagliano to work on a new credit card, and he also helped to oppose changes to a patent law that would be harmful to inventors. Modigliani was a trustee of the Security. For many years, he lived in Belmont, Massachusetts; he died in Cambridge, Massachusetts.

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“The Value of the firm & M. M. theory”- Dividend perspective

Historical background of this theory

Miller and Modigliani derived the theorem and wrote their groundbreaking article when they were both professors at the Graduate School of Industrial Administration (GSIA) of Carnegie Mellon University. The story goes that Miller and Modigliani were set to teach corporate finance for business students despite the fact that they had no prior experience in corporate finance. When they read the material that existed they found it inconsistent so they sat down together to try to figure it out. The result of this was the article in the American Economic Review and what has later been known as the M&M theorem.

M & M. Theorem

The theorem was originally proven under the assumption of no taxes. It is made up of two propositions which can also be extended to a situation with taxes.

ASSUMPTIONS IN THE MODIGLIANI-MILLER APPROACH

• Firms must be in a homogeneous business risk class. If the firms have varying degrees of risk, the market will value the firms at different rates. The earnings of the firms will be capitalized at different costs of capital.

• Investors have homogeneous expectations about expected future EBIT. If investors have different expectations about future EBIT then individual investors will assign different values to the firms. Therefore, the arbitrage process will not be effective.

• Stocks and bonds are traded in perfect capital markets. Therefore, (a) there are no brokerage costs and (b) individuals can borrow at the same rate as corporations. Brokerage fees and varying interest rates will, in effect, lower the surplus available for alternative investment.

• Investors are rational. If by chance, investors were irrational, then they would not go through the entire arbitrage process in order to achieve a higher return. They would be satisfied with the return provided by the leveraged firm.

• There are no corporate taxes. With the existence of corporate taxes the value of the leveraged firm (VL) must be equal to the value of the unleveraged firm (VU) plus the tax shield provided by debt (TD).

.

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“The Value of the firm & M. M. theory”- Dividend perspective

Proposition I: “The value of the firm is independent of the capital structure of the firm”.

Mathematically which can be denotes by the following equation

In case of Tax:

Where,

VL is the value of a levered firm.

VU is the value of an unlevered firm.

TCD is the tax rate (TC) x the value of debt (D)

Without taxes:

Where,

VL is the value of a levered firm.

VU is the value of an unlevered firm

M & M Proposition I and value of the firm:

Let this proposition be justify by an example of two companies; one is levered firm and another one is unlevered firm.

– Two Firms with the same operating income who differ only in capital structure

• Firm U is unlevered: VU=EU

• Firm L is levered: EL= VL-DL

– Strategy 1 – Buy 1% of Firm U’s Equity

• Dollar investment = .01VU

• Dollar Return= .01 Profits

– Strategy 2 – Buy 1% of Firm L’s Equity and Debt

• Dollar investment= .01DL + .01EL = .01VL

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“The Value of the firm & M. M. theory”- Dividend perspective

• Dollar Return=• From owning .01 DL .01 interest• From owning .01 EL .01 (Profits – interest)• Total .01 Profits

• Strategy 3 – Buy 1% of Firm L’s Equity

• Dollar investment = .01EL= .01(VL-DL)

• Dollar Return= .01 (Profits – interest)• Strategy 4

– Buy 1% of Firm U’s Equity and borrow on your own account .01DL (home-made leverage)

• Dollar investment= .01(Vu – DL)

• Dollar Return=• From borrowing .01DL -.01 interest• From owning .01 EU .01 (Profits)• Total .01 (Profits – interest)

All Strategies give the same payoff.

So now we can say, when there is capital markets function, it makes no difference whether the firm borrows or individual shareholders borrow. Therefore, the market value of a company does not depend on its capital structure.

Proposition II: “The return on equity will rise as the debt-equity ratio rises in order to compensate equity holders for the additional (financial) risk”

Mathematically the proposition can be presented like this

Where,

rE is the required rate of return on equity, or cost of levered equity = unlevered equity + financing premium .

r0 is the company cost of equity capital with no leverage (unlevered cost of equity, or return on assets with D/E = 0).

rD is the required rate of return on borrowings, or cost of debt .

D / E is the debt-to-equity ratio.

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“The Value of the firm & M. M. theory”- Dividend perspective

Tc is the tax rateGraphical Presentation of Proposition II:

M & M Proposition II and value of the firm:

M&M Proposition II states that the value of the firm depends on three things:

1) Required rate of return on the firm's assets (Ra)2) Cost of debt of the firm (Rd)3) Debt/Equity ratio of the firm (D/E)

Proposition II can be also stated by the following formula:Re = Ra + (Ra - Rd) x (D/E)

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“The Value of the firm & M. M. theory”- Dividend perspective

Analysis of M&M Proposition II Graph

-The above graph tells us that the Required Rate of Return on the firm (Re) is a linear straight line with a slope of (Ra - Rd)

- IT is Re linear curved and upwards sloping, because as a company borrows more debt (and increases its Debt/Equity ratio), the risk of bankruptcy is even more higher. Since adding more debt is risky, the shareholders demand a higher rate of return (Re) from the firm's business operations.

- As Debt/Equity Ratio Increases -> Re will Increase (upwards sloping).

Moreover if we notice that the Weighted Average Cost of Capital (WACC) in the graph is a straight line with NO slope. It therefore does not have any relationship with the Debt/Equity ratio. This is the basic identity of M&M Proposition I and II, that the capital structure of the firm does not affect its total value.

Optimum capital Structure:

Optimal Capital Structure involves “trading off” costs and benefits. Sometimes it is said that optimum capital structure is when company is financed with 100% debt. But this is not true after reaching a certain point the value of a levered firm tends to decrease as the D/E ratio increases. This scenario is presented with a graph given below:

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“The Value of the firm & M. M. theory”- Dividend perspective

Economic consequences of this theory

While it is difficult to determine the exact extent to which the Modigliani–Miller theorem has impacted the capital markets, the argument can be made that it has been used to promote and expand the use of leverage.

When misinterpreted in practice, the theorem can be used to justify near limitless financial leverage while not properly accounting for the increased risk, especially bankruptcy risk that excessive leverage ratios bring. Since the value of the theorem primarily lies in understanding the violation of the assumptions in practice, rather than the result itself, its application should be focused on understanding the implications that the relaxation of those assumptions bring.

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“The Value of the firm & M. M. theory”- Dividend perspective

Criticisms

The main problem with the Modigliani and Miller (1958) is that they assume shareholders are the owners of the public corporations. This assumption has been refuted by legal scholars since Berle and Means (1932). Shareholders are neither the owners, residual claimants (i.e. owners of the profit), or the investors as 99.9% are in the secondary market.

Advantages of this theory

In practice, it’s fair to say that none of the assumptions are met in the real world, but what the

theorem teaches is that capital structure is important because one or more of the assumptions will

be violated. By applying the theorem’s equations, economists can find the determinants of

optimal capital structure and see how those factors might affect optimal capital structure

To a firm, the most significant everlasting theme is getting the maximum profit with the lowest cost and the least risk. Anybody who studies Corporate Finance knows what an important role the capital structure plays in reducing a firm costs and risks. Capital structure is the ratio of equity and debt. A bad financing decision may result in many forms of higher direct or indirect costs, such as lower stock price, higher cost of capital and lost growth opportunities, increased probability of bankruptcy, higher agency cost and possible wealth transfers from one group of investors to another (Sharma, Kamath and Tuluca, 2003, p. 63). Therefore, how a manager finances a firm becomes a key step to a firm. It is also an important part of Corporate Finance and Managerial Finance. The cornerstone theory of the capital structure is the Modigliani-Miller theory (thereafter MM). MM was developed by two economists, Franco Modigliani, a professor at Massachusetts Institute of Technology, and Merton Miller, a professor at University of Chicago Graduate School of Business (Gifford, 1998). By this main contribution, Modigliani won the Nobel Prize in Economics in 1985 and Miller won the Nobel Prize in Economics in 1990 (Wall Street Jo).

Disadvantages of this theory

Modigliani and Miller’s theorem, which justifies almost unlimited financial leverage, has been

used to boost economic and financial activities. However, its use also resulted in increased

complexity, lack of transparency, and higher risk and uncertainty in those activities. The global

financial crisis of 2008, which saw a number of highly leveraged investment banks fail, has been

in part attributed to excessive leverage ratios.

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“The Value of the firm & M. M. theory”- Dividend perspective

Conclusion

Finally, Miller and Upton (1976) show that firms are indifferent between leasing and buying capital, except when they face different tax rates. Meyers, Dill and Bautista (1976) develop a formula to evaluate the lease versus buy decision, where different tax rates across firms create different discount rates. They show it is optimal for low tax rate, and hence high discount rate firms, to lease. Alchian and Demsetz (1972) show that leasing involves agency costs due to the separation of ownership and control of capital; a lessee may not have the same incentive as an owner to properly use or maintain the capital. Coase (1972) and Bulow (1986) argue that a durable goods monopolist may lease in order to avoid time inconsistency, and Hendel and Lizzari (1999, 2002) show that it may lease to reduce competition or adverse selection in secondary (used goods) markets. Eisfeldt and Rampini (2005) show that leasing has a repossession advantage relative to buying via secured lending. They trade off the benefit of this enforcement advantage against the cost of the standard ownership versus control agency problem.

In addition to these specific advances in financial structure, an essential part of Modigliani and

Miller’s innovation was to put agents on equal footing. They, and others, then asked – what types

of frictions would cause agents to have different market opportunities, information sets or

commitment frictions? This perspective, which was novel at the time, has been used productively

to analyze problems in monetary economics, public finance, international economics, and a

number of other applications. In summary, the most profound and lasting impacts of the

Modigliani-Miller Theorem have been this notion of “even footedness” and the systematic

investigation of the Theorem’s assumptions. The approach has motivated decades of research in

economics and finance in a search for what is relevant in a host of economic problems (between

borrowers and lenders, governments and citizens, and countries). As Miller (1988) said,

“Showing what doesn’t matter can also show, by implication, what does.”

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“The Value of the firm & M. M. theory”- Dividend perspective

References:

Books:1. Fundamentals of Corporate Finance- Stephen Ross, R.W. Westerfield & B. D.

Jordan2. Financial Theories & Coporate Policy- Copeland & Weston

Articles:,

1. Miles, James A., and John R. Ezzell. “The weighted average cost of capital, perfect capital markets and project life: A clarification.” Journal of Financial and Quantitative Analysis 15:3 (September 1980719–730). Online at: dx.doi.org/10.2307/2330405

(1. Modigliani, Franco, and Merton H. Miller. “Corporate income taxes and the

cost of capital: A correction.” American Economic Review 53:3 June 1963): 433–443. Online at: www.jstor.org/stable/1809167

Websites:1. www.wikipedia.com 2. www.google.com 3. www.investorpedia.com