Modigliani-Miller and

Financial Structure

Economics 639 / American University / Vaughan

Financial-Structure Puzzles

Eight interrelated puzzles about financial structure:1. Financial system boasts broad array of marketable securities

and financial intermediaries – heterogeneity is increasing!

2. Internal finance is more important than external finance for firms – not just in U.S. but all over developed world.

3. Firms seeking external finance rely more heavily on banks than securities markets – not just in U.S. but all over developed world.

4. Only large, well established corporations can finance operations by selling securities – not just in U.S. but all over developed world.

2 - 27

Financial-Structure Puzzles(continued)

Eight interrelated puzzles about financial structure:5. U.S. firms selling securities rely more on bonds than stocks.

Pattern is common, but not universal, in developed world.

6. Debt contracts tend to be extremely complicated legal documents placing substantial restrictions on borrowers.

7. As financial markets have grown more sophisticated, financial intermediation has become more important economically.

8. Financial system is heavily regulated – not just in U.S., but all over developed world.

3 - 27

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

4 - 27

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

5 - 27

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 SharesTotal Value of Levered Firm = Total Value of Outstanding Debt +

Total Value of Outstanding Shares

6 - 27

Modigliani-Miller TheoremLogic

Levered Firm:Cash Flows from Assets

- Firm’s Debt Service

Dividends = NetNet Cash Flows

Un-levered Firm:Cash Flows from Assets

= Dividends

- Private Debt Service

= Net 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. 7 - 27

Explanations for Financial-Structure Puzzles

MM valuable not as description of reality, but because it identifies frictions that make financing choices important, namely:1.Transactions Costs

2.Asymmetric Information Costs3.Taxation / Regulation

Financing arrangements reflect efforts to minimize transactions costs, information costs, and tax/ regulatory burden.

8 - 27

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.

9 - 27

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.

10 - 27

Simple Static Trade-Off Theoryof Financial Structure

• 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.

11 - 27

Firm Value Maximized at Debt Level where:Marginal Benefit of Tax Shield = Marginal Expected Bankruptcy Costs

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

12 - 27

Asymmetric-Information Costs Adverse Selection

EXAMPLE:Lemon’s Problems in Financial Markets

1. If investors can't distinguish good from bad securities (lemons), they offer average value.

2. Result: Good securities undervalued, so firms won't issue them; bad securities (lemons) overvalued, so too many issued.

3. No one wants bad securities (lemons), so market falls apart.

13 - 27

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

Asymmetric-Information Costs Adverse Selection

14 - 27

Financial Frictions in Action Pecking 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.

15 - 27

Financial Frictions in Action Pecking Order Theory of Financing

Firms use financing with smallest adverse-selection costs (i.e., smallest information asymmetries) first.

Pecking Order1. Internal Funds2. Bank Debt3. Public Debt4. Public Equity

16 - 27

NOTE: During financial crisis-cum-recession, none of four may be available to finance positive NPV investments. Hence, investment (AD) and real output decline!

Financial Frictions in Action Pecking 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

17 - 27

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: 1. Firm manager (agent) invests external funding in capital

project. 2. Funding providers (principals) cannot observe cash flows. 3. Manager exploits information asymmetry to underreport

cash flows to security holders, then uses funds to pursue personal interests.

Asymmetric-Information Costs Moral Hazard

18 - 27

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:1) Firms rely more on debt than equity.2) Banks provide debt financing (i.e., lend)

• Financial Intermediation (more later)

• Government Regulation

Asymmetric-Information Costs Moral Hazard

19 - 27

Additional Features of Debt Contracts Designed to Reduce Moral Hazard:

• Restrictive covenants

• Collateral requirements

• Net worth requirements

• Reputation (form of collateral or net worth)

Asymmetric-Information Costs Moral Hazard

20 - 27

Financial-Market CatalystsSomewhat Cynical View

Δ Technology

Δ Financial Intermediaries, Financial Markets, and Securities Offered

Economic and Political “Shocks”

Δ Transactions CostsΔ Information CostsΔ Relative Return to

Granting Rents

Δ Taxation / Regulation

21 - 27

Textbook Justifications1. 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

Market Failure!

22 - 27

Financial-Market RegulationSomewhat Cynical View

Two Additional (Better?) Reasons1. Hysterical political reaction to real/

perceived crises

2. “Rent” seeking• Definition: Use of government power to secure

return above opportunity cost (economic rents)

Financial-MarketSomewhat Cynical View

Technological and political/economic shocks alter returns to taxing and regulating.

23 - 27

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 bankingLogic: (i) Underwriting increases risk of commercial banking

(ii) Inherent conflict of interest between two types of banking.

Financial-Market RegulationGlass-Steagall Act (1933)

24 - 27

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.

25 - 27

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.

26 - 27

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 scope available by combining commercial and investment banking.

Mistake not fixed until 1999!

27 - 27