Question

3 (c) Explain briefly how the Modigliani-Miller model with corporate taxes is modified in the presence of bankruptcy costs. What specific conditions are necessary for debtholders to be unaffected by expected bankruptcy costs? Explain. (150 words)

Answer 1

When companies can't pay their debts, they may have very limited options for their future. One of those options may be bankruptcy—the legal term used to describe the process needed to help repay debts and other obligations. While it is always viewed as a last resort, bankruptcy can give companies a fresh start while offering creditors some degree of repayment based on the assets that are available for liquidation.

Bankruptcy usually happens when a company has far more debt than it does equity. While debt in a company's capital structure may be a good way to finance its operations, it does come with risks.

Modigliani-Miller Theorem (M&M)

The Modigliani-Miller theorem (M&M) states that the market value of a company is correctly calculated as the present value of its future earnings and its underlying assets, and is independent of its capital structure.

At its most basic level, the theorem argues that, with certain assumptions in place, it is irrelevant whether a company finances its growth by borrowing, by issuing stock shares, or by reinvesting its profits.

Developed in the 1950s, the theory has had a significant impact on corporate finance.

Understanding the Modigliani-Miller Theorem

Companies have only three ways to raise money to finance their operations and fuel their growth and expansion. They can borrow money by issuing bonds or obtaining loans; they can re-invest their profits in their operations, or they can issue new stock shares to investors.

Modigliani-Miller Theorem

The Modigliani-Miller theorem argues that the option or combination of options that a company chooses has no effect on its real market value.

Merton Miller, one of the two originators of the theorem, explains the concept behind the theory with an analogy in his book, Financial Innovations and Market Volatility:

"Think of the firm as a gigantic tub of whole milk. The farmer can sell the whole milk as is. Or he can separate out the cream and sell it at a considerably higher price than the whole milk would bring. (That's the analog of a firm selling low-yield and hence high-priced debt securities.) But, of course, what the farmer would have left would be skim milk with low butterfat content and that would sell for much less than whole milk. That corresponds to the levered equity. The M and M proposition says that if there were no costs of separation (and, of course, no government dairy-support programs), the cream plus the skim milk would bring the same price as the whole milk."

History of the M&M Theory

Merton Miller and Franco Modigliani conceptualized and developed this theorem, and published it in an article, "The Cost of Capital, Corporation Finance and the Theory of Investment," which appeared in the American Economic Review in the late 1950s.

At the time, both Modigliani and Miller were professors at the Graduate School of Industrial Administration at Carnegie Mellon University. Both were required to teach corporate finance to business students but, unhappily, neither had any experience in corporate finance. After reading the course materials that they were to use, the two professors found the information inconsistent and the concepts flawed. So, they worked together to correct them.

Later Additions

The result was the groundbreaking article published in the economic journal. The information was eventually compiled and organized to become the M&M theorem.

Early on, the two economists realized that their initial theorem left out a number of relevant factors. It left out such matters as taxes and financing costs, effectively arguing its point in the vacuum of a "perfectly efficient market."

Later versions of their theorem addressed these issues, including "Corporate Income Taxes and the Cost of Capital: A Correction," published in the 1960s.

Capital Structures

Companies can use a variety of different methods to finance their operations to achieve an optimal capital structure. The best way to do this is to have a good mix of debt and equity, which includes a combination of preferred and common stock. This combination helps maximize a firm's value in the market while cutting down its cost of capital.

As noted above, companies can use debt financing to their advantage. But as they decide to take on more debt, their weighted average cost of capital (WACC)—the average cost, after taxes, companies have from capital sources to finance themselves—increases. It isn't always such a great idea because the risk to shareholders also rises, as servicing the debt may eat away at the return on investment (ROI)—higher interest payments, which decreases earnings and cash flow. Due to the high debt in the capital structure, the cost to finance that debt increases and the risk of default increases as well.

Bankruptcy Costs

Higher costs of capital and the elevated degree of risk may, in turn, lead to the risk of bankruptcy. As the company adds more debt to its capital structure, the company's WACC increases beyond the optimal level, further increasing bankruptcy costs. Put simply, bankruptcy costs arise when there is a greater likelihood a company will default on its financial obligations. In other words, when a company decides to increase its debt financing rather than use equity.

In order to avoid financial devastation, companies should take into account the cost of bankruptcy when determining how much debt to take on—even whether they should add to their debt levels at all. The cost of bankruptcy can be calculated by multiplying the probability of bankruptcy by its expected overall cost.

Bankruptcy costs vary depending on the structure and size of the company. They generally include legal fees, the loss of human capital, and losses from selling distressed assets. These potential expenses cause the company to try to achieve an optimal capital structure of debt and equity. The company can achieve an optimal capital structure when there is a balance between the tax benefits and cost of both debt financing and equity financing. Traditionally, debt financing is cheaper and has tax benefits through pretax interest payments, but it is also riskier than equity financing and shouldn't be used exclusively.

A company never wants to lever its capital structure beyond this optimal level so that its WACC is high, its interest payments are high and its risk of bankruptcy is high.