© 2000 John Petroff
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© 2000 John Petroff |
3)- Modigliani-Miller propositions
In a classical (1958) article, Modigliani and Miller (MM) showed that financial leverage of a company does not matter to investors because investors can adjust their own personal level of leverage (by lending or borrowing) in line with their risk aversion. The article remains a foundation for modern portfolio theory. In a nut shell, the theory is that corporate capital structure does not matter: the use of debt by a firm will only increase the required rate of return on equity (i.e. and BETA) for that firm.
To reach their conclusions, MM use a set of stringent assumptions: there is no bankruptcy cost, individuals have the same lending and borrowing opportunities as corporations and there are no transaction costs. They show in a series of propositions that the effect of leverage (i.e. comparing the cost of capital of leveraged and unleveraged firms) is to increase the value of the firm but also the cost of equity because of the higher systematic risk. This conclusion is the same as that reached above, but the pattern of average cost of capital is linear in MM. This means that there is no optimum: all capital structures are alike.
Their conclusion is appropriate within their model, and it can be applicable for some of the most stable and prosperous American firms (such as AT& T) for whom debt is a small fraction of total funds and the possibility of bankruptcy is extremely remote. But for most firms that must rely on a much large proportion of debt financing, the assumption of no bankruptcy cost is not appropriate. In addition, analysis of capital structure ought not be focused exclusively on shareholders' view point. Management, employees, customers, suppliers and local government are most seriously concerned with bankruptcy cost. Assuming that it does not exists is impossible to accept in a wider context than the restrictive world of MM. Removing this assumption justifies the rising slopes of equity, debt and average cost of capital, and establish a maximum for debt.
See review questions Q-11E3.1 through Q-11E3.3.
See research assignment R-11E3.1.
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