article on m-m proposition

8/3/2019 Article on M-M proposition

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Table of contentS.L PARTICULERS PAGE NO.

01 Abstract 1

02 Introduction 2

03 About Millar 3

04 About Modigliani 5

05 Modigliani Millar Theorem 6

06 Historical background of their Theories 7

07 Propositions:

Proposition-01Proposotion-02

7

08 Mathematical Formation of this theory 9

09 Graphical Formation of this theory 10

10 Economic consequences of this theory 11

11 Advantages of this theory 11

12 Disadvantages of this theory 12

13 Capital structure Irrelevance 13

14 The dividend Irrelevance theory and company valuation 14

15 Capital structure in perfect market 14

16 Relevant capital structure 15

17 Different Agencies cost in this theory 16

18 Arbitrage of this capital structure 17

19 Unrealistic premises of this theory 17

20 The impact of M.M Theories 19

21 Criticisms of this theory 21

22 Principle conclusion & Reference 23

Abstract

A financial theory stating that the market value of a firm is determined byits earning power and the risk of its underlying assets, and is independentof the way it chooses to finance its investments or distribute dividends.Remember, a firm can choose between three methods of financing:


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issuing shares, borrowing or spending profits (as opposed to dispersingthem to shareholders in dividends). The theorem gets much morecomplicated, but the basic idea is that, under certain assumptions, itmakes no difference whether a firm finances itself with debt or equity.

The ModiglianiMiller theorem states that, in the absence of taxes,bankruptcy costs, and asymmetricinformation, and in an efficient market,a companys value is unaffected by how it is financed, regardless ofwhether the companys capital consists of equities or debt, or acombination of these, or what the dividend policy is. The theorem is alsoknown as the capital structure irrelevance principle. A number of

principles underlie the theorem, which holds under the assumption ofboth taxation and no taxation. The two most important principles are that,first, if there are no taxes, increasing leverage brings no benefits in termsof value creation, and second, that where there are taxes, such benefits, by

way of an interest tax shield, accrue when leverage is introduced and/orincreased.The theorem compares two companiesone unlevered (i.e. financed

purely by equity) and the other levered (i.e. financed partly by equity andpartly by debt)and states that if they are identical in every other waythe value of the two companies is the same.Miller and Modigliani derived the theorem and wrote theirgroundbreaking article when they were both professors at the GraduateSchool of Industrial Administration (GSIA) of Carnegie MellonUniversity. It is said that Miller and Modigliani were set to teachcorporate finance for business students despite the fact that they had no

prior experience in corporate finance. When they read the material thatexisted they found it inconsistent so they sat down together to try tofigure it out. The result of this was the article in the American EconomicReview and what has later been known as the M&M theorem.The theorem was originally proven under the assumption of no taxes. It ismade up of two propositions which can also be extended to a situationwith taxes.Consider two firms which are identical except for their financial

structures. The first (Firm A) is unleveled: that is, it is financed by equityonly. The other (Firm B) is levered: it is financed partly by equity, and

partly by debt. The Modigliani-Miller theorem states that the value of thetwo firms is the same.

IntroductionA firms value is given by the sum of the present value of forecasted cashflows. Resting on Miller and Modiglianis (1961) dividend irrelevance

proposition, practitioners and some academics do not use actual cashflows; rather, they discount potential dividends, also known as free cash

flows or free cash flows to firm (e.g. Damodaran, 2006a,b; Colepand,Koller and Murrin, 2000). Magni and Vlez-Pareja (2009) support the

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idea that only actual cash flows should be discounted, whereas potentialdividends distort valuation in all cases where excess cash retained is notinvested in NPV-neutral investments. In an interesting recent paper,DeAngelo and DeAngelo (2006) revisit Miller and Modiglianis (1961)

paper on dividend policy irrelevance and claim that dividend policy is notirrelevant (see also DeAngelo andDeAngelo, 2007). In the 2006 paper, DeAngelo and DeAngelo (DD)underline the fact that Miller and Modigliani (MM) assume that 100% ormore of the free cash flow is distributed to shareholders, thus shuntingaside the possibility of retention. According to DD, the assumption of no-retention made by MM makes dividend irrelevance a meaninglesstautology .If retention is allowed, then dividend policy is relevant,

because managers could choose suboptimal policies by investing in non-zero NPV projects. This paper shows that relevance or irrelevance of

dividend policy has not to do with retention; it has to do with the rate ofreturn of the extra funds (excess cash) used for reinvestment or financing:dividend policy is irrelevant if and only if zero-NPV activities areundertaken, with or without assumption of retention. The dichotomyretention/no-retention is nevertheless useful, if it is reinterpreted as aregard for agency problems.Modigliani and Miller, two professors in the 1950s, studied capital-structure theory intensely. From their analysis, they developed thecapital-structure irrelevance proposition. Essentially, they hypothesizedthat in perfect markets, it does not matter what capital structure acompany uses to finance its operations.

The MM study is based on the following key assumptions:i) No taxesii) No transaction costsiii) No bankruptcy costsEquivalence in borrowing costs for both companies and investorsSymmetry of market information, meaning companies and investors havethe same informationNo effect of debt on a company's earnings before

interest and taxesIn this simplified view, it can be seen that without taxes and bankruptcycosts, the WACC should remain constant with changes in the company'scapital structure. For example, no matter how the firm borrows, there will

be no tax benefit from interest payments and thus no changes/benefits tothe WACC. Additionally, since there are no changes/benefits fromincreases in debt, the capital structure does not influence a company'sstock price, and the capital structure is therefore irrelevant to a company'sstock price.

About Millar

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Merton Howard Miller (May 16, 1923 June 3, 2000) was the co-author of the Modigliani-Miller theorem which proposed the irrelevanceof debt-equity structure. He shared the Nobel Memorial Prize inEconomic Sciences in 1990, along with Harry Markowitz and WilliamSharpe. Miller spent most of his academic career at the University OfChicago Booth School Of Business.

Early years

Miller was born Jewish, in Boston, Massachusetts to Joel and SylviaMiller, an attorney and housewife.[1] He worked during World War II asan economist in the division of tax research of the Treasury Department,and received a Ph.D. in economics from Johns Hopkins University, 1952.His first academic appointment after receiving his doctorate was VisitingAssistant Lecturer at the London School of Economics.

Career

In 1958, at Carnegie Institute of Technology (now Carnegie Mellon

University), he collaborated with his colleague Franco Modigliani thereto write a paper on The Cost of Capital, Corporate Finance and theTheory of Investment. This paper urged a fundamental objection to thetraditional view of corporate finance, according to which a corporationcan reduce its cost of capital by finding the right debt-to-equity ratio.According to the Modigliani-Miller theorem, on the other hand, there isno right ratio, so corporate managers should seek to minimize tax liabilityand maximize corporate net wealth, letting the debt ratio chips fall wherethey will.

The way in which they arrived at this conclusion made use of the "noarbitrage" argument, i.e. the premise that any state of affairs that will

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allow traders of any market instrument to create a riskless moneymachine will almost immediately disappear. They set the pattern formany arguments based on that premise in subsequent years.

Miller wrote or co-authored eight books. He became a fellow of the

Econometric Society in 1975 and was president of the American FinanceAssociation in 1976. He was on the faculty of the University Of ChicagoGraduate School Of Business from 1961 until his retirement in 1993,although he continued teaching at the school for several more years. Hisworks formed the basis of the "Modigliani-Miller Financial Theory".

He served as a public director on the Chicago Board of Trade 1983-85and the Chicago Mercantile Exchange from 1990 until his death inChicago on June 3, 2000.

Personal life

Miller was married to Eleanor Miller, who died in 1969. He was survivedby his second wife, Katherine Miller, and by three children from his firstmarriage and two grandsons three children by his first marriage: Pamela(1952), Margot (1955), and Louise (1958).

About Modigliani

Franco Modigliani (June 18, 1918 September 25, 2003) was an Italianeconomist at the MIT Sloan School of Management and MIT Departmentof Economics, and winner of theNobel Memorial Prize in Economics in1985.

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Life and career

Born in Rome, Italy, he left Italy in 1939 because of his Jewish origin andantifascist views. He first went to Paris with the family of his then-girlfriend, Serena, whom he married in 1939, and then to the United

States. From 1942 to 1944, he taught at Columbia University and BardCollege as an instructor in economics and statistics. In 1944, he obtainedhis D. Soc. Sci. from theNew School for Social Research working underJacob Marschak. In 1946, he became a naturalized citizen of the UnitedStates, and in 1948, he joined the University of Illinois at Urbana-Champaign faculty.

When he was a professor at the Graduate School of IndustrialAdministration of Carnegie Mellon University in the 1950s and early1960s, Modigliani made two path-breaking contributions to economic

science:Along with Merton Miller, he formulated the important Modigliani-Miller theorem in corporate finance. This theorem demonstrated thatunder certain assumptions, the value of a firm is not affected by whetherit is financed by equity (selling shares) or debt (borrowing money)..In 1962, he joined the faculty at MIT, achieving distinction as an InstituteProfessor, where he stayed until his death. In 1985 he received MIT'sJames R. Killian Faculty Achievement Award. Modigliani also co-authored the textbooks, "Foundations of Financial Markets andInstitutions" and "Capital Markets: Institutions and Instruments" withFrank J. Fabozzi of Management. In the 1990s he teamed up with FrancisVitagliano to work on a new credit card, and he also helped to opposechanges to a patent law that would be harmful to inventors. Modiglianiwas a trustee of the Security. For many years, he lived in Belmont,Massachusetts; he died in Cambridge, Massachusetts.

ModiglianiMiller theorem

The ModiglianiMiller theorem (ofFranco Modigliani, Merton Miller)

forms the basis for modern thinking on capital structure. The basictheorem states that, under a certain market price process (the classicalrandom walk), in the absence of taxes, bankruptcy costs, agency costs,and asymmetric information, and in an efficient market, the value of afirm is unaffected by how that firm is financed.[1] It does not matter if thefirm's capital is raised by issuing stockor selling debt. It does not matterwhat the firm's dividend policy is. Therefore, the ModiglianiMillertheorem is also often called the capital structure irrelevance principle.

Modigliani was awarded the 1985 Nobel Prize in Economics for this and

other contributions. Miller was a professor at the University of Chicagowhen he was awarded the 1990 Nobel Prize in Economics, along with

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Harry Markowitz and William Sharpe, for their "work in the theory offinancial economics," with Miller specifically cited for "fundamentalcontributions to the theory of corporate finance."

Historical background of this theory

Miller and Modigliani derived the theorem and wrote theirgroundbreaking article when they were both professors at the GraduateSchool of Industrial Administration (GSIA) of Carnegie MellonUniversity. The story goes that Miller and Modigliani were set to teachcorporate finance for business students despite the fact that they had no

prior experience in corporate finance. When they read the material thatexisted they found it inconsistent so they sat down together to try tofigure it out. The result of this was the article in theAmerican Economic

Review and what has later been known as the M&M theorem.

Propositions

The theorem was originally proven under the assumption of no taxes. It ismade up of two propositions which can also be extended to a situationwith taxes.

Consider two firms which are identical except for their financialstructures. The first (Firm U) is unlevered: that is, it is financed by equity

only. The other (Firm L) is levered: it is financed partly by equity, andpartly by debt. The ModiglianiMiller theorem states that the value of thetwo firms is the same.

Proposition I:

With taxes

whereVLis the value of a levered firm.

VUis the value of an unlevered firm.TCDis the tax rate (TC) x the value of debt (D)the term TCD assumes debt is perpetualThis means that there are advantages for firms to be levered, sincecorporations can deduct interest payments. Therefore leverage lowers tax

payments. Dividend payments are non-deductible.

Without taxes

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where VUis the value of an unlevered firm = price of buying afirm composed only of equity, and VL is the value of a levered firm =

price of buying a firm that is composed of some mix of debt and equity.Another word for levered isgeared, which has the same meaning.[2]

To see why this should be true, suppose an investor is considering buyingone of the two firms U or L. Instead of purchasing the shares of thelevered firm L, he could purchase the shares of firm U and borrow thesame amount of money B that firm L does. The eventual returns to eitherof these investments would be the same. Therefore the price of L must bethe same as the price of U minus the money borrowed B, which is thevalue of L's debt.This discussion also clarifies the role of some of the theorem'sassumptions. We have implicitly assumed that the investor's cost of

borrowing money is the same as that of the firm, which need not be true

in the presence of asymmetric information, in the absence of efficientmarkets, or if the investor has a different risk profile to the firm.

Proposition II

Their second attempt on capital structure included taxes has identifiedthat as the level of gearing increases by replacing equity with cheap debtthe level of the WACC drops and an optimal capital structure does indeedexist at a point where debt is 100%The following assumptions are made in the propositions with taxes:i) Corporations are taxed at the rate TCon earnings after interest,ii) No transaction costs exist, andiii) Individuals and corporations borrow at the same rate

Miller and Modigliani published a number of follow-up papers discussingsome of these issues.The theorem was first proposed by F. Modigliani and M. Miller in 1958.Proposition II with risky debt. As leverage (D/E) increases, the WACC

(k0) stays constant

i) keis the required rate of return on equity, orcost of equity.ii) k0is the company unlevered cost of capital (ie assume no leverage).

Iii) kdis the required rate of return on borrowings, orcost of debt.iv) D/E is the debt-to-equity ratio.

A higher debt-to-equity ratio leads to a higher required return on equity,because of the higher risk involved for equity-holders in a company withdebt. The formula is derived from the theory ofweighted average cost of

capital (WACC).

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Mathamatical formation of this proposition

whererE is the required rate of return on equity, or costof leveredequity =unleveredequity + financingpremium.r0 is the company cost of equity capital with no leverage (unlevered costof equity, or return on assets with D/E = 0).rDis the required rate of return on borrowings, orcostofdebt.

D /Eis the debt-to-equity ratio.Tcis the tax rate.The same relationship as earlier described stating that the cost of equity

rises with leverage, because the risk to equity rises, still holds. Theformula however has implications for the difference with the WACC

Graphical formaion of this proposition

Proposition II with risky debt. As leverage (D/E) increases, the WACC(k0) stays constant.

keis the required rate of return on equity, orcostofequity.

k0 is the company unlevered cost of capital (ie assume no leverage).kdis the required rate of return on borrowings, orcostofdebt.

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is the debt-to-equity ratio.A higher debt-to-equity ratio leads to a higher required return on equity,

because of the higher risk involved for equity-holders in a company with

debt. The formula is derived from the theory ofweightedaveragecostofcapital (WACC).

Economic consequences of this theory

While it is difficult to determine the exact extent to which theModiglianiMiller theorem has impacted the capital markets, theargument can be made that it has been used to promote and expand theuse of leverage.

When misinterpreted in practice, the theorem can be used to justify nearlimitless financial leverage while not properly accounting for the

increased risk, especially bankruptcy risk, that excessive leverage ratiosbring. Since the value of the theorem primarily lies in understanding theviolation of the assumptions in practice, rather than the result itself, itsapplication should be focused on understanding the implications that therelaxation of those assumptions bring.

Advantages of this theory

In practice, its fair to say that none of the assumptions are met in the real

world, but what the theorem teaches is that capital structure is importantbecause one or more of the assumptions will be violated. By applying the

theorems equations, economists can find the determinants of optimal

capital structure and see how those factors might affect optimal capital

structure

To a firm, the most significant everlasting theme is getting the maximumprofit with the lowest cost and the least risk. Anybody who studiesCorporate Finance knows what an important role the capital structure

plays in reducing a firmfs costs and risks. Capital structure is the ratio

of equity and debt. A bad financing decision may result in many forms ofhigher direct or indirect costs, such as lower stock price, higher cost ofcapital and lost growth opportunities, increased probability of bankruptcy,higher agency cost and possible wealth transfers from one group ofinvestors to another (Sharma, Kamath and Tuluca, 2003, p. 63).Therefore, how a manager finances a firm becomes a key step to a firm. Itis also an important part ofCorporateFinance and Managerial Finance.The cornerstone theory of the capital structure is the Modigliani-Millertheory (thereafter MM). MM was developed by two economists, FrancoModigliani, a professor at Massachusetts Institute of Technology, andMerton Miller, a professor at University of Chicago Graduate School of

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Business (Gifford, 1998). By this main contribution, Modigliani won theNobel Prize in Economics in 1985 and Miller won the Nobel Prize inEconomics in 1990 (Wall Street Jo

Disadvantages of this theory

Modigliani and Millers theorem, which justifies almost unlimited

financial leverage, has been used to boost economic and financial

activities. However, its use also resulted in increased complexity, lack of

transparency, and higher risk and uncertainty in those activities. The

global financial crisis of 2008, which saw a number of highly leveraged

investment banks fail, has been in part attributed to excessive leverage

ratios.

Capital structure irrelevance

Simple financial theory shows that the total value of a company shouldnot change if its capital structure does. This is known as capital structureirrelevance, or Modigliani-Miller (MM) theory. Total value is the valueof all its sources of funding, this is similar to a simple (debt + equity)enterprise value.

The MM argument is simple, the total cash flows a company makes forall investors (debt holders and shareholders) are the same regardless of

capital structure. Changing the capital structure does not change the totalcash flows. Therefore the total value of the assets that give ownership ofthese cash flows should not change. The cash flows will be divided updifferently so the total value of each class of security (e.g. shares and

bonds) will change, but not the total of both added together.

Looking at this another way, if you wanted to buy a company free of itsdebt, you would have to buy the equity and buy, or pay off, the debt.Regardless of the capital structure you would end up owning the samestreams of cash flows. Therefore the cost of acquiring the company free

of debt should be the same regardless of capital structure.Furthermore, it is possible for investors to mimic the effect of thecompany having a different capital structure. For example, if an investorwould prefer a company to be more highly geared this can be simulated

by buying shares and borrowing against them. An who investor wouldprefer the company to be less highly geared can simulate this by buying acombination of its debt and equity.

MM theory depends on simplifying assumptions such as ignoring theeffects of taxes. However, it does provide a starting point that helps

understand what is, and is not, relevant to why capital structure does seemto matter to an extent. The different tax treatments of debt and equity are

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part of the answer, as are agency problems (conflicts of interest betweenshareholders, debt holders and management). There are extensions toMM theory which suggest that the actions of market forces, together withthe tax treatment of debt and equity income in the hands of investors,

means that for most companies the gains that can be made by adjustingcapital structure will be fairly small. Given that companies would notdeliberately adopt inefficient capital structures, we can assume that allcompanies have roughly equivalently good capital structures

So from a valuation point of view we can reasonably assume that capitalstructure is irrelevant. Using enterprise value based valuation ratios suchas EV/EBITDA and EV/Sales implicitly assume that capital structure isirrelevant. Capital structure irrelevance is closely related to dividendirrelevance. Much like their work on the capital-structure irrelevance

proposition, Modigliani and Miller also theorized that, with no taxes orbankruptcy costs, dividend policy is also irrelevant. This is known as the"dividend-irrelevance theory", indicating that there is no effect fromdividends on a company's capital structure or stock price.

MM's dividend-irrelevance theory says that investors can affect theirreturn on a stock regardless of the stock's dividend. For example,suppose, from an investor's perspective, that a company's dividend is too

big. That investor could then buy more stock with the dividend that isover the investor's expectations. Likewise, if, from an investor's

perspective, a company's dividend is too small, an investor could sellsome of the company's stock to replicate the cash flow he or sheexpected. As such, the dividend is irrelevant to investors, meaninginvestors care little about a company's dividend policy since they cansimulate their own.

The Dividend-Irrelevance Theory and Company ValuationIn the determination of the value of a company, dividends is often used.However, MM's dividend-irrelevance theory indicates that there is noeffect from dividends on a company's capital structure or stock price.MM's dividend-irrelevance theory says that investors can affect theirreturn on a stock regardless of the stock's dividend.

For example, suppose, from an investor's perspective, that a company'sdividend is too big. That investor could then buy more stock with thedividend that is over his or her expectations. Likewise, if, from aninvestor's perspective, a company's dividend is to small, an investor couldsell some of the company's stock to replicate the cash flow he or sheexpected. As such, the dividend is irrelevant to investors, meaninginvestors care little about a company's dividend policy since they can

simulate their own..

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The Modigliani-Miller theorem, proposed by Franco Modigliani andMerton Miller, forms the basis for modern thinking on capital structure,though it is generally viewed as a purely theoretical result since itdisregards many important factors in the capital structure decision. The

theorem states that, in a perfect market, how a firm is financed isirrelevant to its value. This result provides the base with which toexamine real world reasons why capital structure is relevant, that is, acompany's value is affected by the capital structure it employs. Someother reasons include bankruptcy costs, agency costs, taxes, andinformation asymmetry. This analysis can then be extended to look atwhether there is in fact an optimal capital structure: the one whichmaximizes the value of the firm.

Capital structure in a perfect market

Consider a perfect capital market (no transaction orbankruptcy costs; perfect information); firms and individuals can borrow at the sameinterest rate; no taxes; and investment decisions aren't affected byfinancing decisions. Modigliani and Miller made two findings under theseconditions. Their first 'proposition' was that the value of a company isindependent of its capital structure. Their second 'proposition' stated thatthe cost of equity for a leveraged firm is equal to the cost of equity for anunrevealed firm, plus an added premium for financial risk. That is, asleverage increases, while the burden of individual risks is shifted betweendifferent investor classes, total risk is conserved and hence no extra value

created.

Their analysis was extended to include the effect of taxes and risky debt.Under a classical tax system, the tax deductibility of interest makes debtfinancing valuable; that is, the cost of capital decreases as the proportionof debt in the capital structure increases. The optimal structure, thenwould be to have virtually no equity at all.

Relevant Capital structure

Trade-off theory

Trade-off theory allows thebankruptcy cost to exist. It states that there isan advantage to financing with debt (namely, the tax benefits of debt) andthat there is a cost of financing with debt (the bankruptcy costs and thefinancial distress costs of debt). The marginal benefit of further increasesin debt declines as debt increases, while the marginal cost increases, sothat a firm that is optimizing its overall value will focus on this trade-offwhen choosing how much debt and equity to use for financing.Empirically, this theory may explain differences in D/E ratios between

industries, but it doesn't explain differences within the same industry.

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Pecking order theory

Pecking Order theory tries to capture the costs of asymmetricinformation. It states that companies prioritize their sources of financing(from internal financing to equity) according to the law of least effort, or

of least resistance, preferring to raise equity as a financing means of lastresort. Hence: internal financing is used first; when that is depleted, thendebt is issued; and when it is no longer sensible to issue any more debt,equity is issued. This theory maintains that businesses adhere to ahierarchy of financing sources and prefer internal financing whenavailable, and debt is preferred over equity if external financing isrequired (equity would mean issuing shares which meant 'bringingexternal ownership' into the company). Thus, the form of debt a firmchooses can act as a signal of its need for external finance. The peckingorder theory is popularized by Myers (1984)[1] when he argues that equityis a less preferred means to raise capital because when managers (who areassumed to know better about true condition of the firm than investors)issue new equity, investors believe that managers think that the firm isovervalued and managers are taking advantage of this over-valuation. Asa result, investors will place a lower value to the new equity issuance.

Tax-PreferenceTheoryTaxes are important considerations for investors. Remember capital gainsare taxed at a lower rate than dividends. As such, investors may prefercapital gains to dividends. This is known as the "tax Preference theory".

Additionally, capital gains are not paid until an investment is actuallysold. Investors can control when capital gains are realized, but, they can'tcontrol dividend payments, over which the related company has control.Capital gains are also not realized in an estate situation. For example,suppose an investor purchased a stock in a company 50 years ago. Theinvestor held the stock until his or her death, when it is passed on to anheir. That heir does not have to pay taxes on that stock's appreciation.

Agency Costs

There are three types of agency costs which can help explain therelevance of capital structure.

Asset substitution effect: As D/E increases, management has anincreased incentive to undertake risky (even negativeNPV) projects.This is because if the project is successful, share holders get all theupside, whereas if it is unsuccessful, debt holders get all the downside.If the projects are undertaken, there is a chance of firm valuedecreasing and a wealth transfer from debt holders to share holders.

Underinvestment problem (or Debt overhang problem): If debt is

risky (e.g., in a growth company), the gain from the project willaccrue to debt holders rather than shareholders. Thus, management

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has an incentive to reject positive NPV projects, even though theyhave the potential to increase firm value.

Free cash flow: unless free cash flow is given back to investors,management has an incentive to destroy firm value through empire

building and perks etc. Increasing leverage imposes financialdiscipline on management.

Arbitrage of this capital structure

Similar questions are also the concern of a variety of speculator known asa capital-structure arbitrageur, see arbitrage.

A capital-structure arbitrageur seeks opportunities created by differentialpricing of various instruments issued by one corporation. Consider, for

example, traditional bonds and convertible bonds. The latter are bondsthat are, under contracted-for conditions, convertible into shares ofequity. The stock-option component of a convertible bond has acalculable value in itself. The value of the whole instrumentshouldbe thevalue of the traditional bondsplus the extra value of the option feature. Ifthe spread (the difference between the convertible and the non-convertible bonds) grows excessively, then the capital-structurearbitrageur will bet that it will converge.

Unrealistic Premises of this theoryThe premises behind the elegant mathematics of the M&M theory wereunrealistic. Some of the assumptions were:

Perfect Markets: The capital market is perfect. No single buyer or sellercan influence security prices or interest rates.

(The Federal Reserve Open Market Committee can not manipulate theprice of treasury bonds and management cannot force prices upwardswith stock buybacks.)

Perfect Knowledge: Information on securities is free and perfect.Investors all know with perfect certainty what the future will bring.

(Standard & Poors and Moodys must go out of business. Companiesnever lie and provide complete and full information at all times.Corporate profits can be predicted with confidence for one hundred yearsor more.)

Free Transactions: There are no brokerage fees, dealer spreads, transfertaxes, or other transaction costs.

(Presumably, there would be no brokers, since there are no fees for

intermediation. There also would be no stock exchanges orclearinghouses.)

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Tax Neutrality: There is no tax difference between debt and equity, orbetween distributed and undistributed profits. Taxes are the same for alltypes of investors. There is no tax on capital gains.

(This means there would be no tax on dividends or interest. Taxes on

dividends paid to corporations, Keogh plans, and individual investorswould be the same.)

Indifference to Cash: Investors are just as happy with unrealized paperprofits as with cash dividends. This is defined as rational behavior.

(Workers in the real world of finance, at the time the theory wasadvanced, measured the value of securities by discounting real cashflows, not paper profits.)

Indifference to Risk: Investors will always prefer to make decisions thatmaximize wealth (paper profits), even if this is more risky than

alternatives. Debt is risk free and its cost is insensitive to changes ininterest rates or risk of bankruptcy.

Indifference to Loan Conditions: The terms of financing are irrelevant.(Managers may finance long-term investments with thirty-day bank loanswith impunity.)

All Players Think Alike: There is no difference in the behavior or goalsof controlling shareholders, minority investors, professional managers,

and institutional investors.Stock and Bond Equivalence. There is no difference between stocks and

bonds. (Investors have no preference for the contractual promise ofbonds, as compared to lack of corporate liability on equities.)What ismost impressive about the M&M Theory is that its assumptions are sodivorced from actual life as to be absurd.

Professors Miller and Modigliani might as well have proposed aJellybean Theory in which investors were made up of gum drops thatwould be soon eaten by a giant rabbit.

The Impact of M&M Theories

Prior to the 1970s, the M&M Theory would have had little effect onfinancial markets, because business people paid scant attention to PhDs,unless they were engaged in building atomic bombs or other trulyscientific endeavors. However, stiff job competition in the dismalseventies created an advantage for job-seekers with MBA degrees.

Consequently, hoards of young MBAs indoctrinated by theoreticaleconomists (without the benefit of on-the-job training in business) beganto fill lower management echelons of banks and industrial corporations.

These brain-washed young men and women brought arrogant notions of a New World Order, singing of betas, alphas, and non-systemic risk.

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Unfortunately, M&M Theory was not only devoid of a basis in reality,but it was also of slight ethical merit.

The M&M Theory had a pernicious effect on corporate governanceand investment markets:

Price Inflation Justified. It became fashionable to value equities bydiscounting future earnings (rather than dividends) and, in doing this, touse marketinterest rates (rather than an investors own expectations).

This inflated the theoretical value of stocks many-fold, justifying price-earnings ratios of fifty and higher. By focusing on earnings, more easilyfalsified than dividends, corporate managers were tempted to pump upfinancial reports in order to increase the value of stock options.

John Burr Williams formula already carried a dangerous seed of over-valuing growth stock, with the Petersburg Paradox.

But the M&M Theory went beyond this, making it possible for academicsand Wall Street hucksters to claim that stocks were still cheap even inmid-2000, when the Great Bubble was about to pop.

Riskier Banking. Conservative bank lending practices of self-liquidatingloans were now pass, since it was theoretically proper to separate the useof funds from the terms of the funding.

This opened wide the door to the roll-over of bank loans as a substitutefor equity, a major cause of the financial crises in Asia in 1997.

Dividends Despised. Stockholders no longer had a theoretical basis todemand dividends. Capital gains were supposedly just as good, evenwhen these gains were the result of manipulation through stock buybacks.

Total return (including paper profits) became the preferred way ofmeasuring investment performance. Without the anchor of cash dividendyields linked to bond yields, equities became increasingly risky andvolatile.

Leverage Enthroned. A high debt load relative to equity was nowacceptable, since the M&M Theory proved that the capital structure of

a firm was irrelevant.Paper Profits, Not Cash. Since temporary, unrealized capital gains weresupposedly just as good as cash dividends, there was intellectual

justification for stock buyback programs and the pilfering of corporateassets by professional managers.

In claiming that corporate capital structure and dividends were irrelevant,the M&M Theory was the economic equivalent of the moral relativismand nihilism that had infected American universities.

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A corporate manager could shuck the traditional fiduciary responsibilityto reward investors with dividends, by claiming that capital gains were

just as good.

Bankers could boost profits by pretending that short-term loans could be

liquidated at will, when in fact corporations needed perpetual roll-oversof bank debt to maintain this substitute for equity.

Criticisms of this theory

The main problem with the Modigliani and Miller (1958) is that theyassume shareholders are the owners of the public corporations. Thisassumption has been refuted by legal scholars since Berle and Means(1932). Shareholders are neither the owners, residual claimants (i.e.owners of the profit), or the investors as 99.9% are in the secondary

market.The formula's use of EBIT / Cost of Capital to calculate a company'svalue is extremely limiting. It also uses the weighted average cost ofcapital formula, which calculates the value based on E + D, where E = thevalue of equity and D = the value of debt. Modigliani and Miller areequating two different formulas to arrive at a number which maximizes afirm's value. It is inappropriate to say that a firm's value is maximizedwhen these two different formulas cross each other because of theirstriking differences. The formula essentially says a firm's value is

maximized when a company has earnings * the discount rate multiple = book value. Modigliani and Miller equate E + D = EBIT / Cost ofCapital. This seems to over-simplify the firm's valuation.

The Principal Conclusion for Dividend Policy

The dividend-irrelevance theory, recall, with no taxes or bankruptcycosts, assumes that a company's dividend policy is irrelevant. Thedividend-irrelevance theory indicates that there is no effect fromdividends on a company's capital structure or stock price.

MM's dividend-irrelevance theory assumes that investors can affect theirreturn on a stock regardless of the stock's dividend. As such, the dividendis irrelevant to an investor, meaning investors care little about acompany's dividend policy when making their purchasing decision sincethey can simulate their own dividend policy.

Reference:

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Aghion, P. and Bolton, P. (1992). An Incomplete Contracts Approach to

Financial Contracting.Review of Economic Studies, 59, 473-94.

Alchian, A. and Demsetz, H. (1972). Production, Information Costs and

Economic Organization.American Economic Review, 62, 777-95.

Allen, F., Bernardo, A. and Welch, I. (2000). A Theory of DividendsBased on Tax Clienteles.Journal of Finance, LV, 2499-2536.

Allen, F. and Gale, D. (1988). Optimal Security Design.Review of

Financial Studies, 1, 229-263.

Allen, F. and Gale, D. (1991). Arbitrage, Short Sales and Financial

Innovation.Econometrica, 59, 1041-68.

Bhattacharya, S. (1979). Imperfect Information, Dividend Policy, and theBird in the Hand Fallacy,Bell Journal of Economics, 10, 259-70.

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article on m-m proposition

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