(6) Valuing firms again – a cookbook
Valuing a company by its capital structure, and why the Modigliani-Miller Model is unconvincing.
Every firm faces the age old question of how to finance themselves. Whether they are new start-up companies or long established market leaders, CFO’s must decide between debt and equity. Ultimately, they are funded with a mix or borrowed money (debt) and owner’s funds (equity). Differences arise depending on the nature of the firm; for publicly traded companies, debt may take the form of bonds and equity is usually common stock, and in a private business, debt is more likely to be bank loans and owner’s savings represent equity. There is no ‘one size fits all’ in capital structure, and each must find their own ‘optimal level’ of debt to equity, given the objective function of maximising firm value. This is known as the optimal debt ratio and will be different for each firm.
With firms going out of business by the day- over 1000 Irish firms were declared insolvent in the first 6 months of 2011 (1), the balance between borrowed money and owner’s equity is more important than ever. What is even more shocking is, despite these figures only 37% of firms have a flexible target when it comes to debt-equity ratios. (2) What does this mean though? Why is having a flexible capital structure target so important, especially in today’s economic climate? Do a firm’s financial leverage decisions affect investor confidence and ultimately the value of the company?
Despite the existence of models such as the Modigliani-Miller model, which argues that the value of a firm is not contingent on its capital structure, I believe the debt-equity ratio is in fact a decisive factor when valuing any financial institution. In an attempt justify my argument I will use the shortcomings of the Modigliani-Miller model, presenting what I feel are the 2 major drawbacks which render it ineffective.
The model states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient markets, a company’s value is unaffected by how it is financed. It is argued that capital structure merely determines how risk is allocated between bondholders and shareholders. Incorporated in this model are two propositions;
1) The market value of a firm is independent of its capital structure
2) The required rate of return on equity increases with financial leverage
I believe the Modigliani-Miller model to be an unrealistic, impractical one which cannot be applied to real markets. There are 2 underlining drawbacks in my opinion, which prevent the model from being relevant.
1) Unrealistic assumptions
Economic models are conceptual frameworks that aid in the understanding, description and/or prediction of human behaviour and although they all rely on certain assumptions on which they work, I feel that the assumptions in the Modigliani-Miller model undermine its validity and integrity completely.
Perfect markets are assumed- therefore no single buyer or seller can influence market prices. To me this is absurd, especially considering the current bond market in the Eurozone. The countless efforts by the ECB to stimulate the sovereign bond market by purchasing government debt would have no effect. The entire financial framework on which governments borrow would be undermined were this assumption to be true.
Similarly, perfect knowledge is assumed- investors all know with ‘prefect certainty’ what the future will bring, speculation will cease to exist and trading as we know will stop.
As ‘All players think alike’, there is a principle agent problem. How can controlling shareholders, managers and minority investors be expected to share the same views regarding the governing of a company.
Stock and bond equivalence means investors have no preference for the contractual promise of bonds, as compared to lack of corporate liabilities on equities.
Assuming tax neutrality, there is no tax difference between debt and equity. This means there is no tax on dividends or interest.
As all transactions are free, there are no brokerage fees, dealer spreads or transfer taxes, thus eliminating the need for brokers and stock exchanges.
Although assumptions are widely seen as necessary for the formation of any economic model, the extent to which the Modigliani-Miller model adjusts economic fundamentals is too great to convince me of its relevance.
2) Promotes high leverage
The model, which justifies almost unlimited financial leverage to boost economic and financial activities. This has resulted in increased complexity, lack of transparency and higher risk and uncertainty in those activities. Particularly given the current financial crisis, not only is this model not suitable, I don’t believe any company will want to, let alone be allowed to operate with such a structure. Modigliani and Miller argue that the capital structure should not affect the choices made by the investors as long as both parties are using the same risk free rate of interest. This promotes the idea that capital structure is irrelevant even when debt is risky, which to me is nonsensical because the substantially higher risk associated with a fully leveraged company must have some effect on how investors value that company. Take for example Kingfisher Airlines, an Indian airline currently facing severe financial problems. With debts of nearly 3$ billion (3), and huge losses over the past 4 quarters, doubt is emerging over the future solvency of the company. As investors have become spooked at the amount of debt associated with the airline, they have been reluctant to buy, causing the share price to collapse. Since January of this year, the share price of Kingfisher has fallen 63% to 25$.
The very definition of a company’s total value or market capitalization is its share price, so the argument put forward by Modigliani and Miller that a high level of debt will not affect the value of a firm is invalid as it is clear it implicitly does. Investor speculation, confidence and demand for a company’s stock will determine its market value. As is the case with Kingfisher and countless other companies who adopted a highly levered capital approach, the existence of large amounts of debt on a balance sheet will deter potential investors, reducing the demand and ultimately price for the stock.
The Modigliani-Miller model for all its repute is, in my opinion, flawed. Although a firm’s value does not depend entirely on the capital structure it operates under, I believe it does have some importance. Both the existence of grossly unrealistic assumptions and the share price uncertainty for a highly leveraged firm lead me to dispute the model and its propositions. The capital structure decisions taken by management can lead to changes in the valuation of a company by investors, a problem that has become increasingly common since the advent of the financial crisis.
References:
2) HOW DO CFOS MAKE CAPITAL BUDGETING AND CAPITAL STRUCTURE DECISIONS? by John Graham and Campbell Harvey, Duke University / Journal of Financial Economics 60 (2001)
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