Modigliani and Millers Advice on Debts Ignored by Companies - Essay Example

? Modigliani and miller’s advice on debts ignored by companies The theorem by Modigliani and Miller, the Nobel Prize-winning organization regarding capital has drawn numerous reactions from various parties. Modigliani and Miller stated that the structure of an organization’s or company’s capital does not matter1. A response towards the proposition by Modigliani and Miller states that the work fails to portray the inefficiencies presence in the real economic world. The presence as well as determination of maxim capital structure tends to be a constant subject of research in the field of corporate finance. Considering the setting of a perfect market, with the absence of frictions, a seminal research conducted by Modigliani and Miller in 1958 proposed that the value of an organization’s market tends to operate in independence of such an organization’s capital structure. The argument by Modigliani and Miller had the essence, adding on the value of debt tends to lower the value of any outstanding capital (equity). Firm’s gain realized by utilizing more of the so seemed cheaper debt will be offset through the implementation of a higher costing policy of the adopted riskier equity. Therefore, considering a fixed value of total equity, the capital allocation between equity and debt will thus be irrelevant since the two capital costs’ weighted average will be of the same amount regardless of any possible combination of the two capital costs2. Unfortunately, no corporation operates in a perfect business world; few if any, are debt financed 100%. Since the realization of the winning paper by Modigliani and Miller, a number of potential explanations regarding the applicability of certain financial structures have emerged, revolving around a number of elements such as the role of taxes, the default cost, credit rationing, equity dilution, and agency costs, while including goals by sponsors and management, yet such goals tend to differ from each other. Another suggestion by Modigliani and Miller is that organizations maintain a capacity of a borrowing reserve in order to accommodate instances of economic uncertainty. It is, therefore, essential to investigate each of the potential inefficiencies mentioned in the prior discussion. Regarding the impact of Taxes, Modigliani and Miller present assumptions which portray obvious violations on the deductibility of payments of interest, and tax as well as corporate taxes. Often, payments on interest committed to debtholders are part of the deductions exercised from corporate revenues before the taxation of such revenues. Consequently, the retained corporate tax plays the role of a subsidy upon interest payments. On the other hand, if the income paid out is in the form of a dividend to stockholders, such an income will undergo double taxation. The initial taxation happens at the level of corporate through corporate taxes, while the subsequent taxation will be exerted on income tax upon holders of equity. Therefore, a corporation striving to reduce taxes while intending to maximize the incomes available to respective investors should, therefore, supports itself financially, entirely through debt3. Default Costs refer to costs associated with distresses of finances, and, more certainly, bankruptcy. Default costs help in keeping the firm from giving large amounts of debt in comparison to the firm’s amount of underlying financing equity. There are two forms of default costs; can either be implicit or explicit. Explicit default costs cover the payments committed to accountants, lawyers, as well as other professionals who advise the firm in instances of liquidation and bankruptcy, or while filling protection forms. Explicit costs can portray an essential fraction of total assets of the corporation. Such fractions are committed to investors during bankruptcy. Additionally, it is essential for corporations to take into consideration, the indirect costs associated with the financial distress incurred when a firm approaches bankruptcy or even default costs. Such costs may cover higher costs emerging from suppliers who may be afraid since the company may fail to meet its bills in the future. Other integral costs may include the value of the loss incurred when customers leave the company in pursuit of long-term and stable relationships with the contextual counterparties and suppliers. Categorically, it would be the preference of investors, to have companies operate without financial or default distress in order to avoid such costs as implicit and explicit costs. However, as corporations take on more debts, the susceptibility of the company suffering from bankruptcy increases sequentially. Therefore, the marginal return of additional increases in debt reduces, while the level of the corporate debt rises. On the same note, there is an increase in marginal cost, in order for the firm to ensure that it optimizes its value in overall. A company will thus focus on marginal trade-offs when deciding the value of equity and debt that the firm ought to adopt for financing its activities. Such factors play a significant role in restraining companies from operating with escalating levels of debt. In any firm, the decision regarding the issuance of corporate debt emerges from the conflict (disagreement) between competing financial sources provided by the equity and debt markets. There are outrageous variances between an organization managed 100% by the owner and an organization whose equity belongs to externally situated stockholders; the second organization may also include a blend of the managers from such an organization, and stockholders from outside. Through external stockholders, managers from an organization serve as the proxy assuming the role of the ultimate owner. Even though these agents (external stockholders and managers) ought to run the activities of the organization in order to maximize the firm’s overall value, they may fail to act as perfect agents regarding owners of the equity since they are sometimes caught up in making some decisions with an ultimate aim of furthering personal interests preceding the ultimate equity owners. There is a high possibility of agents awarding themselves excessive benefits or pay or engage in empire-building in order to increase personal reputations. Agents of equity may also act in favor of the security committed by debtholders instead of the stockholders’ returns. Consequently, the impact of the costs affiliated with this sort of an agency can potentially affect the corporate financial distribution4. An argument by the traditional economics is established on the premise that markets are usually efficient; as similarly presented by the contribution of Modigliani and Miller. In order to minimize potential losses, financial lenders who lack perfect knowledge featured by their counter-parties exhibit an incentive to exercise higher rates upon high-risk lenders. Additionally, they may also ration the credit provision of such counterparties as well. Notably, the lender’s concern is that, following its effort of raising the interest rate exercised for its credits, the firms that are desperately in need of finance will be the ones to access the loans. Supposing that the corporation experiences a bankruptcy, the corporation will therefore manage to recover from its debt as well as settling the account with the lending institution, while underwriting the cost of poor performance. The suggestion hereby is that if a firm can manage to access a high value of loan to finance its operations, such a firm will consequently acquire an enormous incentive in order to implement projects of higher-risk since the level of risk tends to be asymmetric. Often, credit rationing is experienced by younger and smaller corporations, whose owners are most likely to be the founders5. This observation presents a contrast to firms which bear a record used for tracking financial commitments or certain existing investors from outside the corporation. Following the operations of the firms managed by owners, the risk regarding the imperfect knowledge on the counterparts generates tension between debt holders and equity. Shockingly, there is a possibility of having the owner or manager of a self-managed firm bears information that is superior concerning his business, although he additionally adjusts the investment or managerial strategy following the conclusion of a contract ran on a debt. The only corporations capable of taking loans at high rates are such firms with riskier projects. Increasing the interest rate on loans while avoiding credit rationing will cause an increase on the portion of risky borrowers while reducing the lender’s overall profitability. Following the Myers and Majluf in their contribution of 1984, they both presented a research that suggested that owner-managers tend to use debt or equity (external financing) only in instances of inadequate internal financing available to run new projects. Most managers if not all, would prefer the issuance of debt over equity. The ideology behind equity dilution theory holds that managers usually hold a belief that they bear a comparatively better idea regarding the ideal value of their firm compared to potential equity investors or outside bond. An argument may thus be presented, in the process of issuing outside investors with equity, owner–managers may perceive that the corporation is overvalued yet the present owners take the advantage such an overvaluation. The reinforced view is that most managers would prefer debt more than equity in private and smaller companies. Considering the current economic theory, borrowing the ideologies detailed above, the theory of the current economy suggests that there exists an optimal structure of capital which balances the possible risk accompanying bankruptcy with the debt’s tax savings6. Following the establishment, the capital structure ought to potentially provide higher returns to the owners of the stock compared to what they would have obtained from a firm that is all-equity. However, the complexities associated with the competitive environment as well as the extensive corporations’ diversity as well as their immediate competitive environments have an effect on an individual corporation over its optimal capital structure. Essentially, the impact of economic theory can significantly assist in choosing the corporation’s optimal structure of finance. There are other factors which tend to outweigh the economic theory’s pull. Such factors include taxes, the bankruptcy worries, as well as the varying aims of stockholders and bond, specifically during financial distress. Additionally, it is nearly impossible finding the ideal blend of financing concerning an individual corporation. The main reason is because of almost consistently shifting of debt as well as sentiment of equity market in an attempt of responding to perceived return and risk, without ruling out the immediate competitive environment within which an individual corporation operates. However, a firm may choose to benchmark the financing structure to counteract similar industries, competitors, as well as the consultancy of investors and other relevant consultants7. References: Auerbach, Alan J, 1989, Tax Policy and Corporate Borrowing. Chew, Donald H 2001, The New Corporate Finance: Where Theory Meets Practice, McGraw-Hill, New York. Clark, Wendel, How Does Debt Increase a Firm’s Value, viewed 9 May 2012, http://www.ehow.com/info_7909435_debt-increase-firms-value.html Glen, Jack D & Pinto, Brian 1997, Debt or Equity?: How Firms in Developing Countries Choose. International Finance Corporation. Guins, Larry, Modigliani and Miller's Capital Structure Theory (M & M Theory). viewed 9 May 2012, http://campus.murraystate.edu/academic/faculty/lguin/FIN602/Modigliani%20and%20Miller.htm Jaffee, D. M 1971, Credit Rationing and the Credit Loan Market. Wiley, New York. Lowe, Steven, QFINANCE: Issuing Corporate Debt, viewed 9 May 2012, http://www.qfinance.com/contentFiles/QF02/gjbkw9a0/17/0/issuing-corporate-debt.pdf Titman, Sheridan 1984, The Effect of Capital Structure on a Firm’s Liquidation Decision. Myers, C Stewart. Still Searching for optimal Capital Structure. Viewed 9 May 2012, http://www.bostonfed.org/economic/conf/conf33/conf33d.pdf Modigliani, Franco & Merton H Miller 1958, The Cost of Capital, Corporation Finance and the Theory of Investment, The American Economic Review Myers, Stewart C 1977, Determinants of Corporate Borrowing, Journal of Financial Economics. Read More