Debt-Equity Irrelevance: Is this the end of the Miller-Modigliani (MM) Paradigm?
March 9, 2009
Miller-Modigliani (MM) theorem is one of the important cornerstones of the theory of corporate finance. It is actually more than a theorem or a hypothesis. It has been a way of thinking, a system of belief, a paradigm which is in a great way responsible for the rise and a fall of corporate America.
In a 1958 paper, published in the American Economic Review, Franco Modigliani and Merton Miller, two business school professors at Carnegie Mellon, addressed a supposedly important problem in corporate finance: what is the relationship between a firm's capital structure and its value. In other words, they were asking the question: does it matter if a firm is financed with debt or equity.
At the end of that paper, Professors Miller and Modigliani showed that in terms of valuation it does not matter whether a firm is financed with debt or with equity. In fact, the valuation of a firm is independent of its capital structure. This has come to be known as the first MM theorem. More formally, this is known as the "invariance" theorem of corporate finance which states that under certain conditions the value of the firm is invariant to its capital structure.
MM Hypothesis, as the theorem came to be known (of course, this was the first MM theorem, the second one concerned the dividends of the firm), was not something new, at least not in its fundamental concept. John Burr William's 1938 book, The Theory of Investment Value contained what was implicitly an MM worldview of the capital structure of a firm. The book espoused the notion that if the investment value of a firm is the present worth (value) of all the future distributions to security holders in any form, whether interest payments or dividends, then that value does not depend on the capitalization of the firm.
Miller and Modigliani took this as the premise of their paper and using clever algebra and some handy real life examples proved their first theorem.
For almost twenty years after its publication in 1958, the theorem remained mostly in academic wilderness; for sure, finance textbooks were updated, many debates were initiated amongst the academics. And, of course, there were criticisms from corporate treasurers and practitioners and disbelief by many finance chiefs at the sheer absurdity of the proposition as applied to the real world. But more or less the MM theorem remained confined to the corridors of MIT, Carnegie Mellon and other Ivy League Universities.
Then suddenly, beginning early 1980s, MM hypothesis caught the fancy of some investment bankers who were toying with the idea of dumping leverage on a company books and taking it private. The Leveraged Buyout (LBO) boom that started in the early eighties took MM theorem of debt-equity invariance as its defining paradigm and ushered in the age of leverage. In fact, for the next twenty five years, all over the world bankers, investment bankers, private equity partners, and corporate CFOs wholeheartedly embraced the "MM paradigm", as it has come to be known, and this unleashed a frenzy to acquire debt on corporate balance sheets that would be unmatched in the history of the Corporation.
It didn't matter whether debt was cheap or expensive, whether debt was desirable or whether it added any value to the shareholders of the company. Debt was simply good and great because one way or the other it would not affect the valuation of the firm and yet provide capital. Debt Capital Markets teams were born within large banks and private equity funds roared ahead with the mantra of "debt is good" and "more debt is even better". This fuelled a boom in Mergers & Acquisitions (M&A) activity across the U.S. and Europe, and indeed, across the world like never seen before. The entire corporate landscape was transformed overnight.
During the 1980s, 1990s and for most of two thousand there has been a kind of perverse, almost paradoxical, thinking amongst the investor community, especially in the United States that even though theoretically, via the MM theorem, debt made no difference to the valuation of the firm shareholders somehow benefited from its presence on the balance sheet. Besides, the tax structure in the U.S. over the last few decades that has provided enormous incentives to the shareholders to increase leverage on the balance sheet.
The humongous expansion of debt products and the guzzling of debt by all and sundry in Corporate America, and indeed beyond that, was a testimony to the power of MM hypothesis and its influence both within the academia and the industry. Investment banks private equity firms, corporate CFOs, business school professors, all have been the champions of the Miller-Modigliani paradigm. They have all been cheerleaders to a revolution in finance that clearly benefited some but was destined to doom someday.
That revolution, the whole MM paradigm, came undone with the explosion of the sub-prime crisis in the U.S. in 2008 and the subsequent collapse of Lehman Brothers last September.
U.S. consumer is dead, thanks to debt. Big U.S. corporations such as GM, Ford and many others may go bankrupt soon, thanks to the debt and liabilities on their balance sheet. Small and medium sized companies in the U.S. are already dead, thanks to existing debt and their inaccessibility to new debt. This whole L shaped global recession started due to credit crisis and credit means debt in some form or the other. Banks lent money, i.e. debt, to all and sundry, including any corporation that came along and now they won't lend to any one at all. CDOs, CDS and all these other funky credit derivatives is all about debt and so are most of the structured finance instruments and vehicles that the investment banks excelled in peddling in the last decade.
There is no value in equity of the firms today because either there is too much debt on the balance sheet to service or no access to new debt at all. But hey, debt makes no difference to valuation of a firm, right?
Long live the Miller-Modigliani hypothesis! And long live the business school bullshit!
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