Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

1 What is a recapitalisation?

2 What is the fundamental principle of financial leverage?

3 What trade-offs do managers face when they consider changing a company’s capital structure?

CONCEPT REVIEW QUESTIONS 13-1

13 -2 THE MODIGLIANI AND MILLER

PROPOSITIONS

Susan Kelly (in the preceding section) has reached the same capital structure irrelevance conclusion

proposed by two economists more than half a century ago. In 1958, Franco Modigliani and Merton

Miller (hereafter, M & M) published a path-breaking study that challenged conventional thinking about

capital structure.^3 They demonstrated that changes in the mix of debt and equity merely altered the

division of a company’s cash flows between its shareholders and bondholders, but did not fundamentally

affect company value. This conclusion was predicated on several important assumptions:

1 Capital markets are perfect, meaning that investors and companies face no market frictions such as

taxes or transactions costs.

2 Investors can borrow and lend at the same rate that corporations can.

3 Managers and investors have identical information regarding the company’s operations and plans.

Underpinning these ideas are two powerful assumptions about the behaviour of companies and managers

in markets. One assumption is the idea that individuals will always work for the best interests of those

who employ them. This means that we do not have to address ‘principal–agent problems’. A principal–

agent problem is when a person working for someone else (an agent) may act on the basis of personal

interests that do not fit with the interests of her employer (or principal). This can apply for any interaction

between individuals in which one, the principal, is asking the other, the agent – with an incentive that

may be financial or nonfinancial – to do something: for example, a manager being expected to take

actions to maximise the value of the company on behalf of the shareholders of the company.

A crucial element of this relationship in the real world, and the reason why much research in

corporate finance has examined this issue, is that the principal may not be able to examine or understand

the work of the manager, and hence not be able to confirm that the manager is indeed working for the

principal. We discussed this issue in Chapter 1’s section on agency costs. The principal–agent issue is

sometimes also called the hidden action problem, because the agent’s actions are hidden from the view of

the principal, who cannot check on whether or how the agent has undertaken her actions.

The other key assumption that is part of the Modigliani–Miller framework is that information is

not ‘asymmetric’ in its distribution. That is, all individuals in the market possess or can obtain the same

information as any others. Further, if given the same information, each individual will draw the same

3 See Franco Modigliani and Merton Miller, ‘The Cost of Capital, Corporation Finance and the Theory of Investment,’ American Economic

Review, vol. 48, no. 3 (1958), pp. 261–97.