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.
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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.
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Understanding Financial Structure
Modigliani-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
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Understanding Financial Structure
Modigliani-Miller (MM) Theorem
Intuition:
• Cash flows from assets
determine size of pie.
• Capital structure – debt/equity
mix – merely slices up pie.
Debt
Equity
• Firm cannot make pie larger
by slicing differently.
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Modigliani-Miller Theorem
Logic
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
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Modigliani-Miller Theorem
Logic
Levered Firm:
Un-levered Firm:
Cash Flows from Assets
Cash Flows from Assets
- Firm’s Debt Service
= Dividends
Dividends = Net Cash Flows
- Private Debt Service
= 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.
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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 Costs
3. Taxation / Regulation
 Financing arrangements reflect efforts to minimize
transactions costs, information costs, and tax/
regulatory burden.
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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.
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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.
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Simple Static Trade-Off Theory
of 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.
Firm Value Maximized at Debt Level where:
Marginal Benefit of Tax Shield = Marginal Expected Bankruptcy Costs
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Asymmetric-Information Costs
Another 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
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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.
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Asymmetric-Information Costs
Adverse 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
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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.
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Financial Frictions in Action
Pecking Order Theory of Financing
Firms use financing with smallest adverse-selection
costs (i.e., smallest information asymmetries) first.
Pecking Order
1. Internal Funds
2. Bank Debt
3. Public Debt
4. Public Equity
NOTE:
During financial crisis-cumrecession, none of four may be
available to finance positive NPV
investments. Hence, investment
(AD) and real output decline!
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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
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Asymmetric-Information Costs
Moral 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:
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.
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Asymmetric-Information Costs
Moral 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:
1) Firms rely more on debt than equity.
2) Banks provide debt financing (i.e., lend)
• Financial Intermediation (more later)
• Government Regulation
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Asymmetric-Information Costs
Moral 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)
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Financial-Market Catalysts
Somewhat Cynical View
Economic and
Political “Shocks”
Δ Technology
Δ Relative Return to
Granting Rents
Δ Transactions Costs
Δ Information Costs
Δ Taxation / Regulation
Δ Financial Intermediaries, Financial
Markets, and Securities Offered
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Financial-Market Regulation
Somewhat Cynical View
Textbook Justifications
1. 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, anticompetition measures, etc.
3. Improving Monetary Control
– Reserve requirements
– Deposit insurance
Market Failure!
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Financial-Market
Somewhat Cynical View
Two Additional (Better?) Reasons
1. Hysterical political reaction to real/
perceived crises
2. “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.
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Financial-Market Regulation
Glass-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.
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Financial-Market Regulation
Glass-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.
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Financial-Market Regulation
Glass-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.
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Financial-Market Regulation
Glass-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!
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