Modigliani-Miller and Financial Structure

1. Modigliani-Miller and Financial Structure Economics 639 / American University / Vaughan

2. Financial-Structure Puzzles Eight interrelated puzzles about financial structure: • Financial system boasts broad array of marketable securities and financial intermediaries – heterogeneity is increasing! • Internal finance is more important than external finance for firms – not just in U.S. but all over developed world. • Firms seeking external finance rely more heavily on banks than securities markets – not just in U.S. but all over developed world. • Only large, well established corporations can finance operations by selling securities – not just in U.S. but all over developed world.

3. Financial-Structure Puzzles(continued) Eight interrelated puzzles about financial structure: • U.S. firms selling securities rely more on bonds than stocks. Pattern is common, but not universal, in developed world. • Debt contracts tend to be extremely complicated legal documents placing substantial restrictions on borrowers. • As financial markets have grown more sophisticated, financial intermediation has become more important economically. • Financial system is heavily regulated – not just in U.S., but all over developed world.

4. Understanding Financial StructureModigliani-Miller Theorem Theorem: If capital markets are frictionless and competitive, firm value depends solely on cash flows from assets. Capital structure – how firm finances assets – plays no role. Corollary: Net present value (NPV) of investment projects does not depend on method of financing. Frictionless Capital Market (Definition): • No transactions costs • No information asymmetries • No tax or regulatory distortions

5. Understanding Financial StructureModigliani-Miller (MM) Theorem Intuition: • Cash flows from assets determine size of pie. • Capital structure – debt/equity mix – merely slices up pie. • Firm cannot make pie larger by slicing differently. Debt Equity

6. Modigliani-Miller TheoremLogic Consider two firms with identical cash flows from assets: • One has debt (levered firm) in capital structure; other (un-levered firm) doesn’t. • Private investors can borrow on same terms as levered firm. • Total Value of Firm = Market Value of Debt + Market Value of Equity. So: • Total Value of Un-levered Firm = Total Value of Outstanding Shares • Total Value of Levered Firm = Total Value of Outstanding Debt + Total Value of Outstanding Shares

7. Modigliani-Miller TheoremLogic Un-levered Firm: Cash Flows from Assets = Dividends - Private Debt Service = Net Cash Flows Levered Firm: Cash Flows from Assets - Firm’s Debt Service Dividends = Net Cash Flows • Net cash flows are identical. • Investors care only about net cash flows. • Arbitrage guarantees total value of levered firm equals total value of un-levered firm.

8. Explanations for Financial-Structure Puzzles MM valuable not as description of reality, but because it identifies frictions that make financing choices important, namely: • Transactions Costs • Asymmetric Information Costs • Taxation / Regulation • Financing arrangements reflect efforts to minimize transactions costs, information costs, and tax/ regulatory burden.

9. Transactions Costs Definition: Time/money spent channeling funds from surplus to deficit units (i.e., cost of exchange in financial markets). Implication: Small firms – as well as large firms needing small amounts of financing – rely heavily on internal finance and/or banks because transactions costs of issuing securities (such as underwriting fees, SEC disclosure requirements, etc.) are prohibitive.

10. Transactions Costs Another Example:Bankruptcy costs Definition: Loss of firm value from financial distress • Explicit bankruptcy costs: lawyers and accountants fees, etc. • Implicit bankruptcy costs: loss of sales, loss of trade credit, key employees, etc. Implication: Firms with intangible assets and attractive growth opportunities shy away from debt.

11. Simple Static Trade-Off Theoryof Financial Structure Firm Value Maximized at Debt Level where: Marginal Benefit of Tax Shield = Marginal Expected Bankruptcy Costs Interest is tax deductible, so firm value rises with debt. Probability of bankruptcy (and, hence, expected costs from bankruptcy) rise with debt, so firm value falls with debt.

12. Asymmetric-Information CostsAnother Layer of Complexity Definition:Costs of overcoming two types of information problems: • Adverse Selection:Separating good from bad risks (ex ante) EXAMPLE: Groucho Marx and clubs • Moral Hazard: Preventing agent from taking more risk because costs can be shifted to another party (ex post). EXAMPLE: Hit batsmen in American League baseball before/after designated hitter rule

13. Asymmetric-Information CostsAdverse Selection EXAMPLE: Lemon’s Problems in Financial Markets • If investors can't distinguish good from bad securities (lemons), they offer average value. • Result: Good securities undervalued, so firms won't issue them; bad securities (lemons) overvalued, so too many issued. • No one wants bad securities (lemons), so market falls apart.

14. Asymmetric-Information CostsAdverse Selection Potential Solutions • Third-party information production • Limited by free-rider problem • Signaling • Collateral • Net worth • Reputation (form of collateral) • Financial intermediation (more later) • Government regulation

15. Financial Frictions in ActionPecking Order Theory of Financing Adverse selection makes some financing vehicles more expensive than others. Example: • Managers want to issue stock only when overvalued. • Markets know this, so stock issuance seen as “bad” signal. • Thus, issuance depresses price of outstanding stock. • Stock-price decline is part of cost of external finance.

16. Financial Frictions in ActionPecking Order Theory of Financing Firms use financing with smallest adverse-selection costs (i.e., smallest information asymmetries) first. Pecking Order • Internal Funds • Bank Debt • Public Debt • Public Equity NOTE: During financial crisis-cum-recession, none of four may be available to finance positive NPV investments. Hence, investment (AD) and real output decline!

17. Financial Frictions in ActionPecking Order Theory of Financing IMPLICATIONS • “Financial slack” (ready access to low-cost funding) is valuable. • Observed capital structure reflects availability of positive NPV projects(i.e., projects are accepted using funding according to pecking order until no positive NPV projects no longer available available). • No optimal debt/equity mix

18. Asymmetric-Information CostsMoral Hazard Principal-Agent Problem: Principal designates agent to act on his behalf. Because monitoring/ disciplining is costly, agent can pursue his own interest at principal’s expense. EXAMPLE: • Firm manager (agent) invests external funding in capital project. • Funding providers (principals) cannot observe cash flows. • Manager exploits information asymmetry to underreport cash flows to security holders, then uses funds to pursue personal interests.

19. Asymmetric-Information CostsMoral Hazard Potential Solutions • Debt Finance • Reduces cost of monitoring firms because information about cash flows from projects not needed as long as debt-service obligations met. • Focus going forward on debt because: • Firms rely more on debt than equity. • Banks provide debt financing (i.e., lend) • Financial Intermediation (more later) • Government Regulation

20. Asymmetric-Information CostsMoral Hazard Additional Features of Debt Contracts Designed to Reduce Moral Hazard: • Restrictive covenants • Collateral requirements • Net worth requirements • Reputation (form of collateral or net worth)

21. Financial-Market CatalystsSomewhat Cynical View Economic and Political “Shocks” Δ Technology Δ Transactions Costs Δ Information Costs Δ Relative Return to Granting Rents Δ Taxation / Regulation Δ Financial Intermediaries, Financial Markets, and Securities Offered

22. Market Failure! Financial-Market RegulationSomewhat Cynical View Textbook Justifications • Increase Information Flow to Investors • Such as reporting requirements to decreases adverse selection/moral hazard problems 2. Ensuring Soundness of Financial Intermediaries • Chartering, reporting requirements, restrictions on assets and activities, deposit insurance, anti-competition measures, etc. 3. Improving Monetary Control • Reserve requirements • Deposit insurance

23. Financial-MarketSomewhat Cynical View Two Additional (Better?) Reasons • Hysterical political reaction to real/ perceived crises • “Rent” seeking • Definition: Use of government power to secure return above opportunity cost (economic rents) Technological and political/economic shocks alter returns to taxing and regulating.

24. Financial-Market RegulationGlass-Steagall Act (1933) EXAMPLE: Hysterical political reaction to real/perceived crisis plus rent seeking. Problem • Commercial banks moved aggressively into securities underwriting in 1920s, subsequently failed in droves. • Pecora Commission(1933-34) investigated financial collapse. • Sensational hearings generated outcry (particularly against securities underwriting by Chase & National City). Solution: Separate investment, commercial banking Logic: (i) Underwriting increases risk of commercial banking(ii) Inherent conflict of interest between two types of banking.

25. Financial-Market RegulationGlass-Steagall Act (1933) But...something else was going on! • House of Morgan and Rockefeller family were most important private economic entities in U.S. • Both big in banking • In 1929, Winthorp Aldrich (WA) became president of Equitable Trust (in Rockefeller empire), which later merged with Chase. • Aldrich’s father was Rhode Island Senator for 30 years, key player in Fed creation, and John D Rockefeller’s “man” on the Hill.

26. Financial-Market RegulationGlass-Steagall Act (1933) But...something else was going on! (continued) • Pecora Commission exposed shady underwriting by Chase and National City (Rockefeller bank, too), so WA countered by championing divorce of investment and commercial banking. Rationale • Good public relations • House of Morgan had extensive “universal” banking operations, so investment/commercial banking divorce would hurt them more.

27. Mistake not fixed until 1999! Financial-Market RegulationGlass-Steagall Act (1933) What Happened Next? • Portfolio theory/subsequent empirical research showed combining commercial and investment banking reduced risk. • Research on 1920s (Kroszner-Rajan, among others) showed bonds underwritten by investment-bank subs of commercial banks performed well →No evidence of massive fraud/ conflicts of interest, apart from Chase and National City. • U.S. households/firms lost economies of scopeavailable by combining commercial and investment banking.