The Bombshell Assertions

The Bombshell Assertions

Prepared by: Rajan Thakur

Introduction ► The

article tries to explain the Modigliani Miller (M&M) theory. ► The theory is about capital structure, whether a company should be financed by debt or equity.

Franco Modigliani ► Was

born in Italy ► immigrated to NYC in 1939 ► Got his Phd at New School in NYC. ► Had 25 years of teaching experience when he collaborated with Miller in 1956 at Canegie Tech University.

Melton Miller ► Was

born in Boston, MA ► Got Bachelor’s degree at Harvard ► Phd at John Hopkins University ► Had 5 years of teaching experience when he collaborated with Modigliani ► They met at Carnegie Tech in 1952

The Starting Point… ► Miller’s

question: How a corporation should select securities to sell to arrive at an optimal balance between debt and equity. ► Goal of a finance officer: To raise the money for the company on the most favorable terms. The Higher price of security, the less interest and the smaller share of the company to sell.

Findings of a Research ► The

amount of borrowing didn't have any effect on the cost of capital ► Strategic role of business spending on plant and equipment

Modigliani ► Durand’s

Assertion: The cost of capital of a leveraged company is less than a company without debt. ► But Modigliani had suspect on this finding and believed that the value of a company is independent of its capital structure ► Whether a company borrows a lot or a little, its cost of capital will remain the same.

The Theorem ► The

value of the company’s bonds and stock will depend on the company’s overall expected earnings power and the basic risks the company faces. ► Conditions: No Tax No moment transaction costs The information is freely available to everyone

Impact of Arbitrage ► Also

known as Law of One Price ► Equalizes the market values of companies with equivalent earning power and riskiness regardless of how they are financed. ► GM and GE shares

The Impact of Risk ► GM

and GE shares

Criticisms ► After

publishing their article called “The cost of capital, corporation finance and the theory of investment” a lot of scholars reacted negatively. ► Their assumptions were unrealistic in the real world. ► But M and M stated that if the value of the company does not depend on capital structure, MM theory at least defines the necessary conditions under which that will happen.

Criticisms: Affect of dividend payments ► Dividends

paid today shrink the assets of the company and reduce its future earning power.* ► It affects how the company finances its growth. ► The value of the company will still depend on its growth potential and its riskiness.

Continued ► In

real World: Stock prices go up when dividends are raised Financing decisions dominate growth strategies If MM theory failures, it still reveals what the companies should do.

Affect of Tax ► Taxation

encourages borrowing and increases earning power. ► Interest payment is tax deductable. ► Debt finance should increase the value of the company.

Conclusion ► If

today a new research was made, this result would be come up with: ► Corporations with approximately the same earning power and the same degree of riskiness continue to have significantly different capital structure. ► In the real world, MM theory is looks remarkably sturdy.