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Modigliani-Miller Theorem :
The history of science is made of contradictions. Who can imagine that a theorem can have so much success, just because their authors have demonstrated that something is totally irrelevant. Her is the case of Modigliani-Miller Theorem
The irrelevance principal
The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm, this is to say the market value, is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt, if the firm is paying dividends or interest, in other terns. It does not matter what the firm's dividend policy or the financial structure is. Therefore the capital structure irrelevance principle refers to Modigliani & Miller’s theorem.
The Thesis
Being VL the value of a levered company, the price you have to pay to adquire the Levered firm
Being VU the value of an unlevered company, the price you have to pay to adquire the Unlevered firm
VL = VU
In other words, the Value of a levered company equals the Value of the same company, which would be and unlevered company. The value of the company is independent of the way it chooses to finance its investments or distribute dividends.
How to convince yourself
First of all, the present paper es a tremendous reduction to the so called real world.
To see why this should be true, suppose an investor is considering buying one of the two firms U or L. Instead of purchasing the shares of the levered firm L, he could purchase the 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. Therefore the price of L must be the same as the price of U minus the money borrowed B, which is the value of L's debt.
This discussion also clarifies the role of some of the theorem's assumptions. We have implicitly assumed that the investor's cost of borrowing money is the same as that of the firm, which need not be true in the presence of asymmetric information or in the absence of efficient markets.
ke = k0 + (D/E) (k0-ke)
ke is the required rate of return on equity, or cost of equity.
k0 is the cost of capital for an all equity firm.
kd is the required rate of return on borrowings, or cost of debt.
D / E is the debt-to-equity ratio.
A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt. The formula is derived from the theory of weighted average cost of capital.
These propositions are true assuming the following assumptions: no taxes exist, no transaction costs exist, and individuals and corporations borrow at the same rates.
These results might seem irrelevant (after all, none of the conditions are met in the real world), but the theorem is still taught and studied because it tells us something very important. That is, capital structure matters precisely because one or more of these assumptions are violated. It tells us where to look for determinants of optimal capital structure and how those factors might affect optimal capital structure.
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 that excessive leverage ratios bring. In particular the theory does not account for the bankruptcy risk associated with debt as compared to equity stakes. 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.
It can also be misinterpreted to justify excessive leverage in order to extend margins for trading operations, even though this action should not be directly comparable to the capital structure of a financial entity.
The Dot.com companies
Too much leverage increases unfairly the value of the Balance Sheet. Consequently the Balance Sheet does not reliably reflects the situation of the firm, and make really difficult the estimate its fair value. That is what partially provoqued the end of the technological bubble. The leverage level of many Dot.com companies was too high, and their Balance Sheet irrelevant. When analysts begun to be aware of that, it was too late, the fair value of many Dot.com companies was quite lower inversor thought it was. Inversors begun to sale their equities and then begun the end of the Technological Bubble.
The history of science is made of contradictions. Who can imagine that a theorem can have so much success, just because their authors have demonstrated that something is totally irrelevant. Her is the case of Modigliani-Miller Theorem
The irrelevance principal
The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm, this is to say the market value, is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt, if the firm is paying dividends or interest, in other terns. It does not matter what the firm's dividend policy or the financial structure is. Therefore the capital structure irrelevance principle refers to Modigliani & Miller’s theorem.
The Thesis
Being VL the value of a levered company, the price you have to pay to adquire the Levered firm
Being VU the value of an unlevered company, the price you have to pay to adquire the Unlevered firm
VL = VU
In other words, the Value of a levered company equals the Value of the same company, which would be and unlevered company. The value of the company is independent of the way it chooses to finance its investments or distribute dividends.
How to convince yourself
First of all, the present paper es a tremendous reduction to the so called real world.
To see why this should be true, suppose an investor is considering buying one of the two firms U or L. Instead of purchasing the shares of the levered firm L, he could purchase the 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. Therefore the price of L must be the same as the price of U minus the money borrowed B, which is the value of L's debt.
This discussion also clarifies the role of some of the theorem's assumptions. We have implicitly assumed that the investor's cost of borrowing money is the same as that of the firm, which need not be true in the presence of asymmetric information or in the absence of efficient markets.
ke = k0 + (D/E) (k0-ke)
ke is the required rate of return on equity, or cost of equity.
k0 is the cost of capital for an all equity firm.
kd is the required rate of return on borrowings, or cost of debt.
D / E is the debt-to-equity ratio.
A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt. The formula is derived from the theory of weighted average cost of capital.
These propositions are true assuming the following assumptions: no taxes exist, no transaction costs exist, and individuals and corporations borrow at the same rates.
These results might seem irrelevant (after all, none of the conditions are met in the real world), but the theorem is still taught and studied because it tells us something very important. That is, capital structure matters precisely because one or more of these assumptions are violated. It tells us where to look for determinants of optimal capital structure and how those factors might affect optimal capital structure.
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 that excessive leverage ratios bring. In particular the theory does not account for the bankruptcy risk associated with debt as compared to equity stakes. 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.
It can also be misinterpreted to justify excessive leverage in order to extend margins for trading operations, even though this action should not be directly comparable to the capital structure of a financial entity.
The Dot.com companies
Too much leverage increases unfairly the value of the Balance Sheet. Consequently the Balance Sheet does not reliably reflects the situation of the firm, and make really difficult the estimate its fair value. That is what partially provoqued the end of the technological bubble. The leverage level of many Dot.com companies was too high, and their Balance Sheet irrelevant. When analysts begun to be aware of that, it was too late, the fair value of many Dot.com companies was quite lower inversor thought it was. Inversors begun to sale their equities and then begun the end of the Technological Bubble.