by 3aidlillahi » Tue 02 Dec 2008, 10:00:25
$this->bbcode_second_pass_quote('', 'T')his revolves around the theory by two Professors, Franco Modigliani, Merton Miller, commonly known as the Miller-Modigliani theorem (M&M!) who won a Noble Prize for this. In fact, the theory itself is quite simple, and as we are learn several times in academics, many of the Noble Prize winners haven’t come up with ground-breaking new research, but rather summarized/clarified/put-in-a-nutshell what was already obvious, i.e. be able to explain a phenomena that everyone kind of already knew but couldn’t quite explain before!
Here’s what M&M proposed:
In the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm’s capital is raised by issuing stock or selling debt. It does not matter what the firm’s dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle. [Wiki]
The point? Debt is irrelevant. In other words, debt, by itself does not create value. In fact, an individual could mimic a company’s debt structure and make the company’s decision irrelevant.
So, let’s say there is a company A that has 20% of debt in its capital structure (i.e. how the company is financed) with the balance 80% being equity (shares, etc.). There is another debt-free company B, with exactly the same operating performance as A (i.e. they both generate the same profits and have the same assets). An individual could then use 80% of his money to buy shares of company A, and borrow 20% from the bank, and essentially mimic company A (assume that interest rate is same for individual and company). So, in essence, B cannot differentiate itself from A by simply borrowing, because an individual investor could do the same. And then in a perfect market, where everything is known about A and B, arbitrage will prevent one company from being valued higher than the other. Miller said it best:
“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 says 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 the argument is that increasing the amount of debt (cream) lowers the value of outstanding equity (skim milk) – selling off safe cash flows to debt-holders leaves the firm with more lower valued equity, keeping the total value of the firm unchanged. Put differently, any gain from using more of what might seem to be cheaper debt is offset by the higher cost of now 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.
Muslimmatters.org
I know little about this theory (that won the Noble Prize) but I found this analysis interesting given our problem with debt.
Now I don't mean that taxes alone are the problem for debt but that they are one that can most easily be taken care of where an efficient market, bankruptcy costs and others can not (to my knowledge).
It'll be interesting to see how well this theory holds in places like Dubai which are devoid of taxes.
Riches are not from abundance of worldly goods, but from a contented mind.
