© 2000 John Petroff
|
|
© 2000 John Petroff |
4)- Threat of financial distress
Modigliani-Miller propositions are valid in a world where financial distress is ignored or insignificant. In a previous section, it was argued that the major burden of financial risk is the potential of bankruptcy. If this has to be assumed then the increasing cost of debt justifies the derivation of a minimum optimal cost of capital.
Whether the assumption of financial distress should be retained or not is essentially an empirical question. If the firms that an analyst is studying are not likely to fall in financial difficulties, then the assumption must be kept, but if bankruptcy is a real possibility for the firm under study then the assumption is inappropriate.
Thus, let us look at empirical evidence. According to the U.S. Small Business Administration, Office of Advocacy USELM files (as reported in Statistical Abstracts 1991, page 538), the proportion of annual business failures during the period 1980-1988 was 9.3% among small businesses (defined as businesses with less than 500 employees). This period covers an entire business cycle, and includes a trough in 1982 and a long period of expansion as shown in Table T-15.1, Business Cycle Expansions and Contractions 1919-1990. Averages for that period can be representative of normal business conditions. The 9.3% average tells that a little less than one out of every ten small businesses can be expected to close each year.
Table T-13.5 Net Profit Margin % in seven US sectors by size of sales in 1999 shows that the average profit of the smaller firms in manufacturing in 1999 is negative. This means that the majority of manufacturing small firms are in financial difficulties. Yet 1999 is a very prosperous year by any standard. How serious is the situation for these small firms? One can judge this from Table T-11.15 - Proportion of equity by company size in eight US sectors in 1999 and Graph G-11.8 - Proportion of equity by company size in seven US sectors in 1999, which show that the majority of small firms are grossly undercapitalized (three times less capital than larger firms) not just in manufacturing, but in information and services sectors as well.
The next question is whether small firms are just marginal or represent the bulk of business. The answer is present in Table T-14.2 - Number of US firms by number of employees in 1987: it shows that small firms (i.e. firms with less than 100 employees in this context) represent 98% of businesses. Even in manufacturing the proportion of small firms is 90%. It is true that 2% of large firms produce 90% of output and own 90% of assets. But, large firms are not immune to bankruptcies: witness the number of large failures during the great depression.
One can guess that blue chip firms
that are included in the Dow Jones averages are not concerned
with the potential for bankruptcy. There may be about another
hundred firms or so in the United States, that are in this situation.
But this text is not written for the analysis of the largest firms,
but all firms. Therefore, the assumption of lack of bankruptcy
cost is not relevant for the majority of the business population
involved in the present discussion.
See review questions Q-11E4.1
through Q-11E4.3.
See research assignment R-11E4.1.
| Previous: 3-Irrelevance |
|
|
Next: Differences |