Thursday, February 27, 2014

Capital Structure and the Fictional World of Miller-Modigliani

Capital structure is a key element in any acquisition.  How should a deal be financed?  How much debt can an acquisition support?  What are the resulting shifts in ownership structure?   What debt rating will result from a deal?  These are just a few of the key questions related to capital structure.

In previous posts, we've discussed some basic theories of capital structure (for just two examples see High Leverage Deals, Capital Structure and Common Sense and How Much Debt is Right for your Deal?).  The theoretical foundation for understanding capital structure starts with the classic work by Miller and Modigliani published way back in 1958.  That enormously influential work, showed that the level of debt doesn't matter in a hypothetical world where: taxes don't exist, bankruptcy costs are zero and there are no informational asymmetries (all parties have complete information).

Many of our readers will recall discussing this work in their MBA programs, but for many practitioners the idea of starting with such a hypothetical, completely fictional world seems insane. Wouldn't we all like to live in a world without taxes, bankruptcy costs or informational blockages! But the analysis is not  insane.  Rather it is the starting point for understanding all that matters in capital structure today.

The starting point of Miller and Modigliani can be likened to the scientist who analyzes the properties of some item in a complete vacuum.   He/she starts the analysis in a vacuum, not because it represents the real world, but because if we can't understand how things work in that idealized experiment, we can't hope to understand how things work in our complex environment.

Rather than objecting to the assumptions as ivory tower irrelevancies, consider these assumptions as the starting point for a very important experiment.  For indeed, under these assumptions, the level of debt does not matter.  So ------ if the amount of debt matters --- (and we live in the real world and we know the level of debt matters) --- it matters precisely because of the effects of these assumptions.  Rather than being irrelevant, when we relax the assumptions, debt does indeed affect firm value - and it does so because of the existence of taxes, bankruptcy costs and information.  In future posts we'll explore each of these assumptions and their implications for capital structure in a bit more detail.

All the best,


No comments:

Post a Comment