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Capital Structure: Modigliani & Miller’s Theory

Reasons why Modigliani & Miller’s propositions were initially misunderstood

Modigliani and Miller’s propositions were initially misunderstood because of the irrelevance of the propositions that were proving to be irrelevant, still raising hackles in academic circles. The criticism revolving around M&M’s failure to recognize the great importance of adhering to taxes among other issues like incurring costs in hiring lawyers in times of bankruptcy is expected. Most people could not understand how exactly preposition 1 on M&M functioned. This states that the form of value of a firm is independent of its capital structure (capital structure being the equity-funded or debt-funded business). Traditionally, people knew that the mode of financing a business matters a lot when it comes to raising capital. Equity ratio and debt are the main financing formulae that in most cases, managers use to finance their businesses, usually mixing them in a given ratio to maximize investments and minimize risks as much as possible (Parrino & Kidwell, 2009).

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M&M preposition also failed to give the remedy and its statement of noting matters. At least it could have given or shed light on what and how managers benefit from such propositions. Failing to do so also got managers more confused about the whole thing in general. Its assumption of perfect market also gave way to more questions than answers since the market is not perfect so to speak. In addition, when bankers intend to increase capital, M&M is not obliged to incur cost of investment bankers. It is however important to state that some practice is expected to be adhered to as a benchmark when designing economic models (Parrino & Kidwell, 2009).

Consequences of M&M propositions

Modigliani-Miller’s theory has an impact on the nature of capital markets in the global markets. The amount of impact that the M&M theorem has on the capital markets is measured by its impact on the advantage to any organization. It can be misinterpreted in practical scenarios, which may provide the notion of endless financial leverage. It is very hard indeed to try to figure out by how much has the theorem has had an impact on any institution, in this matter, the financial markets. It is a notion that has made many firms use leverage to finance their capital needs. The issue of dividend payment also plays an important role in M&M theorem arbitrage. How exactly to pay dividends within the framework of M&M is the main problem. Invariance preposition, which is stated as “The dividend invariance proposition stated only that, given the firm’s investment decision, its dividend decision would have no effect on the value of the shares” (Eckbo, 2008, p. 127).

The application should be based on understanding the impacts brought about by relaxing the assumptions. The M&M theorem is valued depending on how the assumptions are violated, rather than basing the value on the results obtained as well as how the theory is applied (Eckbo, 2008).

Optimal Capital Structure

In the real world, this has not been possible given the many theorems besides the M&M. Many have tried but none has made any substantial study and come up with satisfactory results that show that it can be achieved. The M&M theorem tried to make assumptions that are not only attainable in a market but also based on mere theory not yet proved. It only exists in theory; moreover, the theory does not provide any methodology that firms can use to achieve optimal capital structure. Managers can only approximate the optimal structure. The optimal capital structure may be real if the conditions of M&M are met. Since perfect markets do not exist in the financial markets it becomes to get optimal benefits. Not to be perfect in this sense but try and improve their future cash flows and ensure that they service the debt fully and within a set time. This will ensure that the firm’s assets are not repossessed by the financier and are declared bankrupt in the process. Finance capital structure is defined as the manner in which corporate organization finances their assets by combining equity, debt or by combining the two aspects. The relevance of capital structure has been under question when it comes to perfectly competitive markets. This has been due to the fact that attaining a perfect market condition is largely an ideal. Some of the conditions it should meet include firms and individuals can borrow at the same interest rate; no taxes; and Investment decisions are not affected by financing decisions (Crouhy, Galai & Mark, 2006).

Assumptions of M&M theory

  1. Perfect Markets: this means there are many players in the market i.e. many lenders and many firms that can borrow finances from the many financers and everyone has the perfect information. This will facilitate easy trade between the partners I.e. The capital market is perfect
  2. Single interest rate.
  3. The Federal Reserve Open Market Committee cannot manipulate the price of treasury bonds and management cannot force prices upwards with stock buybacks. Companies never lie and provide full information at all times. Corporate profits can be predicted with confidence for one hundred years or more.
  4. Free Transactions: There are no brokerage fees, dealer spreads, transfer taxes, or other transaction costs. Presumably, there would be no brokers, since there are no fees for intermediation. There also would be no stock exchanges or clearinghouses (Focardi, Frank & Fabozzi, 2004).
  5. There is no tax on capital gains. It is evident that laws relating to corporate tax give higher benefits to debt financing (usually the positive aspects outdo risks) as opposed to their favor towards equity financing. This will mean more funds to finance the project at hand. Corporate and personal taxes do influence capital structures (Herbst, 2010).

Effects of financial distress costs and agency costs on M&M theory

Corporate tax determines capital structure. There is a difference in the tax treatment of dividends to common shareholders and interest paid to bondholders at the corporate level. Because interest expense is deductible from corporate income while dividends are not, bond financing leads to a “tax subsidy” to the firm. The trade-off theory provides that firms are seeking debt levels, which can balance the advantages in tax caused by an increase in debt because of costs of financial distress. It predicts a moderate amount of debt as optimal (Correia, Flynn, Uliana, Wormald, 2007). But there is evidence that the most profitable firms in an industry tend to borrow the least, while their probability of entering into financial distress seems to be very low (Broyles, 2003).

High advantage tends to improve the efficiency of the managers, this will make investors consider the issue of new debt favorably, and therefore agency costs can come into play in different ways. This is the point where those vested in the management of the firm start to act in their own interests and the firms’ best interests. This might bring about conflict of interests. Agency costs also add up to the firms’ costs. Where taxes are paid, it is tighter to get new debt from lenders since they will scrutinize the firm further. The lenders make sure that the management does not take excessively more risk with the lenders’ money. Bankruptcy is also another cost that is part of agency cost. Although perceived as minimal, it affects the firm’s credibility which in the end will affect the firms’ image. Its share price will also go down and subsequently, financiers would not dare finance a bankrupt firm because they will not be able to service their debt.

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Debt financing is an issue also because firms will only lend to those with less risk of defaulting loans. Firms that pay tax with minimal agency cost and less financial distress show a good sign of a performing firm, thus lenders will scrutinize their books before making any loan on the same. This will put managers on the heels to ensure they follow all procedures to get affordable finances. Monitoring costs are incurred in the monitoring of expenditures made by the agents, bonding costs are incurred in drawing up contracts and agreements by the principal with the agent and also taxes levied leaves the agents with lesser freedom to operate and has its own opportunity costs, in terms of a residual loss to the firm. This will in turn restrict the issue of equity/ debt, depending on the situation. Capital structure is therefore influenced by these costs (Barker & Powel, 2005).

References

Barker, H. & Powel, G. (2005). Understanding financial management: a practical guide. Netherlands: Black line Publishers.

Broyles, J. E. (2003). Financial management and real options. England: John Wiley and Sons

Correia, C., Flynn, D., Uliana, E. & Wormald, M. (2007). Financial management. Cape Town: Juta and Company Ltd.

Crouhy, M., Galai, D. & Mark, R. (2006). The essentials of risk management. New Jersey, NJ: McGraw-Hill Professional

Eckbo, B. E. (2008). Handbook of corporate finance: empirical corporate finance. Netherlands: Elsevier.

Focardi, S., Frank, J. & Fabozzi, (2004). The mathematics of financial modeling and investment management. New York, NY: John Wiley and Sons

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Herbst, A. F. (2010). Capital asset investment: strategy, tactics & tool. United Kingdom: John Wiley & Sons ltd.

Parrino, R. & Kidwell, D. S. (2009). Fundamentals of corporate finance. New York, NY: John Wiley and Sons

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StudyCorgi. 2022. "Capital Structure: Modigliani & Miller’s Theory." July 30, 2022. https://studycorgi.com/capital-structure-modigliani-and-amp-millers-theory/.

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