Financial Structure Puzzle

The short answer is that insiders as well as outsiders (commercial banks, investment banks, rating agencies, venture capitalists, equityholders, etc.) devote a lot of attention to its design. But we must also ask whether this attention is warranted. As a matter of fact, economists were stunned when, in two articles in 1958 and 1961, Modigliani and Miller came up with the following rather striking and somewhat counterintuitive result. Under some conditions, the total value of the firm—that is, the value of all claims over the firm’s income—is independent of the financial structure. That is, the level of debt, the split of debt into claims with different levels of collateral and different seniorities in the case of bankruptcy, dividend distributions, and many other characteristics or policies relative to the financial structure have no impact on total value. In other words, decisions concerning the financial structure affect only how the “corporate pie” (the statistical distribution of income that the firm generates) is shared, but has no effect on the total size of the pie. Thus, an increase in debt or a dividend distribution dilutes the debt-holders’ claim and benefits the shareholders, but the latter’s gain exactly offsets the former’s loss.  Let VE and VD denote the values of equity and debt for debt repayment D. Then the total value,

                                  

V e +V_D=  È _max (0,R-D) +È(min(R,D))

           = È(R)

is independent of D, where E(·) denotes the expectation with respect to the distribution of the random variable R. Add to this result the observation that efficient corporate policies should aim at maximizing the size of the corporate pie: any increase in the firm’s total value Add to this result the observation that efficient corporate policies should aim at maximizing the size of the corporate pie: any increase in the firm’s total value brought about by a change in policy can be divided among the claimholders in a way that makes everyone better off.10 Modigliani and Miller’s conclusion then follows: the financial structure is irrelevant. Managers and investors might as well devote their time to more useful tasks and simplify their financial structure by issuing a single claim, which could be labeled “100% equity” or “equity without debt” (this is the claim depicted by the 45° line in Figure 2.1). The firm would then become an “all-equity firm.” Similarly, the payout policy (dividends and share repurchases/issuance) has no impact on firm value. To illustrate this, consider an all-equity firm, again with risk-neutral investors. Time is discrete: t = 0,1,2,…. In each period t, a random net revenue Rt accrues; then a per-share dividend dt is paid, the number of shares is adjusted from nt−1 to nt, and an investment It is sunk.11 Consider, for each t, a given (state-contingent) investment policy It, as well as an (also state-contingent) choice of dividend dt and number of shares nt (nt nt−1 in the case of share repurchases, nt > nt−1 when new shares are issued). Let Pt denote the price of a share at the end of period t (after the dividend payment) and β the discount factor. By arbitrage,

P_t = βÈ (d_t+1+ d_t-1)