Debt or Equity Funding - Shall we ask M & M?
January 2, 2007
This is one of those classic Does it Matter questions. Does it really matter whether a company decides to raise capital through debt or equity?
In our previous posting we outlined a corporate finance case (see the section Case Analyses) whereby the senior management has to decide whether it wants to go the ˇ§debt" route or the "equity" route to raise capital. The relationship between a firm's capital structure, i.e. how much of the capital is in the form of debt and how much in equity, and its valuation was brought to the forefront of financial theory by Modigiliani and Miller (M & M) in their celebrated 1958 paper. Here they argued that a firm's debt or equity has no impact over its overall value. The only variable that determined the firm's value was its future earnings power, as measured by the expected cash flows from its operations. More specifically, the weighted average cost of capital (WACC) was completely unaffected by the method of financing.
Even at that time there was a lot of opposition to this idea. Many argued that debt was a great value-enhancer and that WACC was indeed critically impacted by the amount of debt in the balance sheet of a firm. And this additional value - some theorists look at it as some sort of a bonus - is captured by the tax rate in the economy multiplied by the amount of debt. Interest payments on the debt are tax deductible and hence the cost of debt, i.e. the interest charged on the debt, needs to be adjusted by the tax rate for proper WACC calculations. This deduction in the WACC is actually reflected as a bonus value in the value of the firm.
Besides, the attractiveness of debt - all forms of debt - as a financing vehicle to certain segment of investors would also become a major factor in the capital market dynamics in the decades to come, though of course, M & M couldn't have anticipated it at that time. In fact, in 1963, M & M published another follow up paper on this topic which clarified their position further. They stated that they had, in fact, underestimated the important contribution to a firm's value made by the tax subsidy on debt interest payments and the lower capitalization rate that results from these tax benefits. In this paper they reasoned that a firm should indeed lower its capitalization rate by raising debt a receiving a "bonus" equal to the tax rate times the debt.
And a key point to note in their thesis was that the value of the leveraged firm would increase - would become evident to investors - regardless of the amount of debt. Could this really be the case? Is it really the case, even today, that no matter how much debt a firm raises its value will keep rising? It is a tough one to accept, given the empirical results. It is obvious and logical that as the amount of debt in the balance sheet rises so does the chances of default and bankruptcy and the agency costs associated with bankruptcy. And that will most certainly destroy value, quantifying the equilibrium point beyond which there is no incremental addition to the overall value of the firm as we keep adding debt but rather a lowering of value could be very difficult to establish.
Nevertheless, almost twenty years after the publication of M&M's 1963 thesis the US capital markets were taken by storm by the leveraged buyout mania, when debt, and all forms of debt, including below investment grade junk, became the mantra of corporate raiders, investors and senior management executives of US firms.
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