CHAPTER ONE
INTRODUCTION
1.1 BACKGROUND OF THE STUDY
The Modigliani-Miller theorem is one of the cornerstones of modern corporate finance. At its heart, the theorem is an irrelevance proposition; the Modigliani-Miller theorem provides conditions under which a firm’s financial mix does not affect its value. No wonder, Modigliani (1980, xiii) explains the theorem as follows:
… with well-functioning market (and neutral taxes) and rational investors,
who can undo the corporate financial structure by holding positive or
negative amount of debt, the market value of the firm-debt plus equity,depends only on the streams of income generated by its assets. It follows,
in particular, that the value of the firm should not be affected by the share of debt in its financial structure or by what will be done with the returns paid out as dividend or reinvested (profitably)…
In fact, what is currently understood as the Modigliani-Miller theorem comprises three distinct results from a series of papers (1958, 1961 and 1963). The first proposition establishes that under certain conditions, a firm’s debt-equity ratio does not affect its market value. The second proposition establishes that a firm’s leverage has no effect on its weighted average cost of capital (that is, the cost of equity capital is a linear function of the debt-equity ratio) while the third proposition establishes that the firm’s value is independent of its dividend policy.
Miller (1991:217) succinctly explains the intuition for the theorem with a simple analogy, he says;
…think of the firm as a gigantic tub of whole milk. The
farmer can sell the whole milk as it is, or he can separate
out the cream and sell it at a considerably higher price than
the whole milk would bring…
He continues
…the Modigliani-Miller proposition say that if there were no
costs of separation (and of course, no government dairy
support program), the cream plus the skim milk would bring
the same price as the whole milk…
The essence of Miller’s argument is that, increasing the amount of debt (cream) lowers the ratio of outstanding equity (skim milk) – selling off safe cash flows to debtholders which leaves the firm with more valued equity thus keeping the total value of the firm unchanged. Put differently, any gain from using more of what might be seem to be a cheaper debt is offset by the higher cost of riskier equity. Hence, given a fixed amount of total capital, the allocation of capital between debt and equity is irrelevant because the weighted average of the two costs of capital to the firm is the same for all possible combinations of the two.
Spurred by Modigliani and Miller’s (1958, 1961 and 1963) arguments, that in an ideal world without taxes a firm’s value is independent of its debt-equity mix, economists have sought conditions under which the financial structure of the firm would matter. Economic and financial theories suggest that several factors influence the debt-equity mix such as differential taxation of income from different sources, informational asymmetries, bankruptcy cost/risks, issues of control and dilution and the agency problem (see Hart, 2001).
Thus, in line with the above, the question now is? Do corporate financing decisions affect firm’s value? How much do they add and what factor(s) contribute to this effect? An enormous research effort, both theoretical and empirical has been devoted towards sensible answers to these questions since the works of Modigliani and Miller (1953, 1961, and 1963). Several foreign and local scholars have theoretically and empirically studied the impact of the firm’s financial mix on the value of the firm from different perspective (see, Jensen and Meckling, 1976; Jensen, 1986; Fama and Miller, 1972; Myers, 1977; Miller and Scholes, 1978; Elton and Gruber, 1970; among others).
In fact, Elton and Gruber (1970) studied the link between taxes, financing decisions and firm value and found that personal taxes make dividend less valuable that capital gain and stock prices fall by less than the full amount of the dividend on ex-dividend days. Fama and Miller’s (1972) study on the financial structure of the firm was on leverage and they argue that leverage (debt finance) can increase the incentive of the stockholders to make risky investment that shift wealth from bondholders but do not maximize the combined wealth of security holders, thus, value is not created. Jensen and Meckling (1976) evaluating financial structure from the agency cost model submit that higher leverage allow managers to hold a larger part of its common stock thereby reducing agency problem by closely aligning the interest of the managers and other stockholders, thus asserting that since the interest of stockholders are protected, value is created. In another paper by Jensen (1986), he said leverage (debt finance) used by the firm enhances value by forcing the firm to pay out resources that might otherwise be wasted on bad investment by managers.
Myers (1977) argues that leverage (debt finance) can make firms to under invest because the gains from investment are shared with the existing risky bonds of the firm. In effect, the agency effect of financing decision work through profitability and can make firms to take better or worse investments and to use assets more or less efficiently. Miller (1977) re-evaluating earlier MM theories on financial structure argues that if common stock is priced as tax free but personal tax rate built into the pricing of the stock, corporate interest payment is then the corporation tax rate. Hence, the tax shield at the corporate level is offset by taxes on interest at the personal level thus debt does not affect firm value. He therefore submit that if there are two firms with the same earnings, before interest and taxes, the more levered firm’s higher after-tax earnings are just offset by the higher personal taxes paid by its bondholders. Therefore, given pre-tax earnings, there is no relationship between debt and value.