This is from the “Accounting Makes Cents” podcast episode #19 released on Monday, 8 August 2022.
This week we are covering a theoretical topic on capital structures. This one is sometimes referred to as M&M, no, not the chocolates, but if it helps you remember it faster, then by all means think about this as the chocolate theory. M&M stands for Modigliani and Miller. Modigliani and Miller were two economists who came up with the M&M theorem. Basically the theory revolves around the main idea that the capital structure of a company does not affect its value. Let’s dive into it a little bit deeper. Let’s start off with the official stance of this theory.
Jump to show notes.
What is the M&M Theorem?
The M&M theory starts from a position that the value of a company that is funded only by equity (we shall now refer to as the unlevered company) is equal to the value of a company that is funded in parts by equity and in parts by debt (so this other company is referred to as the levered company in this case). So why is this the case? So why would the value of the levered company be the same as the unlevered company?
Miller, one of the M&Ms, explained this in a finance book, using the analogy of a farmer selling milk. The farmer can sell the whole milk as is and fetch a specific amount for it. Let’s say $100, so we can have a monetary visual on it. Now, the farmer could strip the milk and separate it into cream and skim milk. The reason he’ll do this is that he can likely fetch a higher amount for the cream. Let’s say in this case, $70 for the cream part. However, he’ll be left with the skim milk, which he won’t really be able to sell at premium and could likely only sell at a reduced price. So in this case, let’s say $30 for skim milk. In total, whether the farmer sells the whole milk or he sells it separately as cream and skim milk, the value he gets is the same.
How does this equate to the theory? Well, the whole milk is basically the unlevered company, the one funded with equity only. It remains whole with a specific value. The cream and skim milk is the levered company, the one funded part-equity, part-debt. It might be beneficial to obtain debt because it is a cheaper method of funding, but then it does raise the equity risk, thereby raising the cost of equity, hence when put together with the higher cost of equity and the lower cost of debt, you should arrive at the same weighted average cost of capital (or WACC).
Assumptions
But of course, this theory is effective only if we have the following assumptions:
- The market is perfectly efficient, wherein share prices reflect all information about the company
- Taxes are ignored in the situation
- Bankruptcy exists but there are no bankruptcy costs if it were to happen
As you can see the assumptions are not quite realistic and has kinda highlighted the limitations of the first version of the M&M theory. M&M exists in a perfect world, and we know that we don’t really live in one.
The birth of M&M II
Anyway, Modigliani and Miller introduced a second version of their theory to deal with some of the issues of the first version and kinda make sure that it’s more relatable in a real world situation. So we shall call this revised version M&M II where taxes are in existence.
M&M II Proposition 1 (with tax)
M&M II proposition 1 discusses the value of the levered company, being higher because of the tax shield involved in the interest payment on the debt that the company has. As mentioned, tax comes into the equation. There is financial benefit as interest is a tax-deductible item and saves the company taxes. In this proposition, the more the company is funded with debt, the more WACC is reduced, thereby making it better for the company.
This thinking is not quite correct, because again, it is slightly in a perfect, ideal world. The more debt you take on, the better. But in the real world, while there is some benefit to taking on debt, too much debt is really risky. There is the possibility of bankruptcy or default.
M&M II Proposition 2 (with tax)
So Modigliani and Miller came up with a second proposition, the M&M II Proposition 2. In this proposition, tax is in the M&M theory but they do acknowledge that cost of equity increases as the company takes on more debt. So M&M II proposition 2 is kinda a mix of M&M II proposition 1 and original M&M.
Anyways, in M&M II proposition 2, the company takes on more debt, the cost of equity does increase because of higher risks involved with taking on more debt, but because there is a tax shield benefit to the debt, cost of equity doesn’t rise as fast as it would in the perfect world scenario.
In essence, M&M II proposition 2 arrives at the conclusion that there is a slight benefit to funding the company with debt.
Show notes simplified
In today’s episode, MJ the tutor tackles the technically heavy topic of Modigliani and Miller’s theory on capital structures. She looks at the different propositions raised by this theory, from the original to the revised ones to make them more relatable to real world situations.
Credits:
“Ding Ding Small Bell” (https://freesound.org/s/173932/) by JohnsonBrandEditing (https://www.youtube.com/channel/UC1RImxnsbfngagfXd_GWCDQ) licensed under CC0 Licence.
MJ THE TUTOR 