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Planners use model that only works in vacuum
By Shawn Mesaros |
June 4, 2013, Tuesday
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Print Edition
Print Edition
IT has often been said that debt doesn't matter in the hallowed halls of academia.
When considering the finance alternatives to "cash vs debt," there are many theses that would suggest that, in a vacuum, "capital structure doesn't matter," which was popularized many years ago by an award-winning team known as "Miller Modigliani."
By their own admission, this famous duo had no actual ideas about corporate finance despite being asked to teach the subject. They reviewed existing work on the subject, and formed their own theories which somehow made it to mainstream academia.
We present for argument, one of the most widely used theories in modern finance: The Miller Modigliani Hypothesis.
In the Miller Modigliani framework, "MM" hypothesized that "capital structure doesn't matter," meaning that if one financed a business with 100 percent debt or 100 percent equity, that the resulting business would be the same, since in a vacuum, the "aggregate value" of total investment would have also been the same. Of course, we understand that this is ridiculous in hindsight. People do incredible stupid things when they spend other people's money vs their own money. What about sustainability?
We are far less interested in debating debt as "good or evil" as a method of funding a business, and more interested in the conversation regarding "behavioral differences" between debt financed companies and equity financed companies.
Some would perhaps correctly argue that "some debt" is good as it keeps management on its toes, drives for more efficiency, and so on, whereas too much debt may lead to riskier behavior of managers trying to "qualify" or remain within "covenants" set by their creditors.
What people can generally agree on is that a 100 percent debt financed business may have far less value than a 100 percent equity financed business. Why?
Simple. A 100 percent debt financed business has the burden of debt, and zero ownership of the company by management in which case the incentive to drive the business is rationally impaired. The only carrot left for management is that without performance comes the loss of one's job, but no other known incentive.
A 100-percent equity financed business perhaps must, by virtue of its zero debt structure, remain highly cautious, it will not give away equity to new people since owners are directly tied to the profitability of the firm, and investment decisions must be much more conservatively made, lest management throws valuable working capital into investments without proper focus on the "return" on those investments.
Investment cycles and related return cycles would behaviorally trend "longer" vs shorter, and probably take more "collective" votes since everyone's equity would be directly affected.
Modern-day finance and government spending and central planning among governments looks much like a highly ingenious version of the famous Miller Modigliani financial framework. Comparisons are so uncannily similar that it must be seen to be believed.
Modern-day politicians in America would content that not only does debt not matter but also the idea that whomever spends that money, as a second derivative of "MM" also doesn't matter since under this apparently altered "MM" framework, "who spends the money" as a percentage of GDP no longer matters, either.
In fact, if the general public spends the money and invests for growth, that's fine, but if the government spends the money instead, well then we are calling that "equal" under the revised and government imposed "MM" Framework.
As outside debt investment or borrowing is used to substitute human capital, we begin to throw the sustainability argument out the window, no better explained as the US borrows more and more money to finance GDP which cannot grow on its own.
The author is managing director of Pacific Asset Management. The views are his own.
When considering the finance alternatives to "cash vs debt," there are many theses that would suggest that, in a vacuum, "capital structure doesn't matter," which was popularized many years ago by an award-winning team known as "Miller Modigliani."
By their own admission, this famous duo had no actual ideas about corporate finance despite being asked to teach the subject. They reviewed existing work on the subject, and formed their own theories which somehow made it to mainstream academia.
We present for argument, one of the most widely used theories in modern finance: The Miller Modigliani Hypothesis.
In the Miller Modigliani framework, "MM" hypothesized that "capital structure doesn't matter," meaning that if one financed a business with 100 percent debt or 100 percent equity, that the resulting business would be the same, since in a vacuum, the "aggregate value" of total investment would have also been the same. Of course, we understand that this is ridiculous in hindsight. People do incredible stupid things when they spend other people's money vs their own money. What about sustainability?
We are far less interested in debating debt as "good or evil" as a method of funding a business, and more interested in the conversation regarding "behavioral differences" between debt financed companies and equity financed companies.
Some would perhaps correctly argue that "some debt" is good as it keeps management on its toes, drives for more efficiency, and so on, whereas too much debt may lead to riskier behavior of managers trying to "qualify" or remain within "covenants" set by their creditors.
What people can generally agree on is that a 100 percent debt financed business may have far less value than a 100 percent equity financed business. Why?
Simple. A 100 percent debt financed business has the burden of debt, and zero ownership of the company by management in which case the incentive to drive the business is rationally impaired. The only carrot left for management is that without performance comes the loss of one's job, but no other known incentive.
A 100-percent equity financed business perhaps must, by virtue of its zero debt structure, remain highly cautious, it will not give away equity to new people since owners are directly tied to the profitability of the firm, and investment decisions must be much more conservatively made, lest management throws valuable working capital into investments without proper focus on the "return" on those investments.
Investment cycles and related return cycles would behaviorally trend "longer" vs shorter, and probably take more "collective" votes since everyone's equity would be directly affected.
Modern-day finance and government spending and central planning among governments looks much like a highly ingenious version of the famous Miller Modigliani financial framework. Comparisons are so uncannily similar that it must be seen to be believed.
Modern-day politicians in America would content that not only does debt not matter but also the idea that whomever spends that money, as a second derivative of "MM" also doesn't matter since under this apparently altered "MM" framework, "who spends the money" as a percentage of GDP no longer matters, either.
In fact, if the general public spends the money and invests for growth, that's fine, but if the government spends the money instead, well then we are calling that "equal" under the revised and government imposed "MM" Framework.
As outside debt investment or borrowing is used to substitute human capital, we begin to throw the sustainability argument out the window, no better explained as the US borrows more and more money to finance GDP which cannot grow on its own.
The author is managing director of Pacific Asset Management. The views are his own.
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