Modigliani-Miller and Financial Structure. 2-26 Financial-Structure Puzzles Eight, interrelated puzzles, about financial structure: 1.The financial system.

Modigliani-Miller and

Financial Structure

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Financial-Structure Puzzles

Eight, interrelated puzzles, about financial structure:1. The financial system boasts a broad array of marketable

securities and financial intermediaries—and the degree of heterogeneity is increasing.

2. Internal finance is more important than external finance for firms—not just in the U.S., but all over the developed world.

3. When firms seek external finance, they rely more heavily on banks than on the securities markets—not just in the U.S. but all over the developed world.

4. Only large, well established corporations can tap securities markets to finance their operations—not just in the U.S. but all over the developed world.

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Financial-Structure Puzzles(continued)

Eight, interrelated puzzles, about financial structure:5. When U.S. firms do sell securities, they rely more heavily on

bonds than on stocks. This pattern is common, but not universal, in the developed world.

6. Debt contracts typically are extremely complicated legal documents that place substantial restrictions on borrowers.

• Collateral is a common feature of debt contracts.

7. As financial markets have grown more sophisticated, financial intermediation has become more important economically.

8. The financial system is heavily regulated—not just in the U.S., but all over the developed world.

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Understanding Financial Structure:The Modigliani-Miller Theorem

Theorem: If capital markets are frictionless and competitive, then a firm’s value will depend solely on the cash flows from its assets. The firm’s capital structure—the manner in which the assets are financed—will play no role.

Corollary: The NPV of an investment project will not depend on the manner of financing.

Definition: Frictionless capital market

• No transactions costs

• No information asymmetries

• No tax or regulatory distortions

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Understanding Financial Structure:The Modigliani-Miller Theorem

Intuition: • The cash flows from assets

determine the size of the pie.

• Capital structure—the debt/equity mix—merely slices up the pie.

• The firm cannot make the size of the pie large by slicing it differently.

Debt Equity

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The Modigliani-Miller Theorem:The Logic

Consider two firms with identical cash flows from assets:

• One has debt (the levered firm) in its capital structure; the other (the un-levered firm) does not.

• Investors can borrow privately on the same terms as the levered firm.

• The total value of a firm is defined as the market value of its debt plus the market value of its 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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The Modigliani-Miller Theorem:The Logic

Levered Firm:Cash Flows from Assets

- Firm’s Debt Service

Dividends = Net Cash Flows

Un-levered Firm:Cash Flows from Assets

= Dividends

- Private Debt Service

= Net Cash Flows

• The net cash flows are identical.• Investors care only about net cash flows. • Arbitrage guarantees that the total value of the levered

firm will equal the total value of the un-levered firm.

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Explanations for Financial Structure Puzzles

MM identifies frictions that make financing choices important:

1. Transactions costs 2. Asymmetric information costs3. Taxation and Regulation

Financing arrangements reflect efforts to minimize transactions costs, information costs, tax burden, and regulatory burden.

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Transactions Costs

Definition: The time and money spent channeling funds from surplus units to deficit units.

Forms:• Search costs• Negotiation costs• Enforcement costs

Implication: Small firms and large firms needing small amounts of financing will rely on internal finance or on bank finance.

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Transactions Costs

Another Form: Bankruptcy costs

Definition: Loss of firm value arising 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 will shy away from debt financing.

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Asymmetric-Information Costs

Definition: The costs of overcoming two types of information problems:

• Adverse selection: separating good from bad risks before execution of a financial contract.

• Moral hazard: insuring that economic agents with delegated authority live up to the terms of their contracts.

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Asymmetric-Information Costs: Adverse Selection

Example—Lemon’s Problems in Financial Markets:1. If investors can't distinguish between good and bad

securities, they will offer only the average value.

2. Result: Good securities will be undervalued, so firms won't issue them; bad securities will be overvalued, so too many will be issued.

3. Investors do not want bad securities, so market falls apart.

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Solutions to Lemon’s Problem in Financial Markets:

• Information production by disinterested third party– Limited by free-rider problem

• Signaling– collateral

– net worth

– reputation (a form of collateral)

• Government regulation

• Financial intermediation

Asymmetric-Information Costs: Adverse Selection

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Financial Frictions in Action: The Pecking Order Theory of Financing

Adverse selection make some financing vehicles much more expensive than others.

Example: • Managers want to issue new stock only when it is

overvalued.

• Stock issuance is a “bad” signal.

• Stock issuance causes the price of outstanding stock to fall.

• Decline in stock price is part of the cost of external finance.

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Financial Frictions in Action: The Pecking Order Theory of Financing

Firms use financing with the smallest adverse selection costs—that is, the smallest information asymmetries—first.

Pecking order:1. Internal Funds

2. Bank Debt

3. Public Debt

4. Public Equity

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Financial Frictions in Action: The Pecking Order Theory of Financing

Implications: • Financial slack is valuable.

• Observed capital structures reflect availability of positive net present value projects.

No optimal debt/equity mix.

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Principal-Agent Problem: Principal designates an agent to act on his behalf. But because monitoring and disciplining are costly, the agent has scope to pursue his own interest at the expense of the principal.

Examples: 1. Separation of ownership from control allows managers to

use firm resources to pursue their own interests rather than maximize shareholder value.

2. Separation of savers and investors allows investors to use surplus funds to pursue their own interests rather than accept the capital projects with the highest net present value.

Asymmetric-Information Costs: Moral Hazard

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Solutions to moral-hazard problems in financial markets:

• Debt finance

– Motivates managers to maximize shareholder value by absorbing “free cash flow”

– Reduces costs of monitoring investors

• Government regulation

• Financial intermediation

Asymmetric-Information Costs: Moral Hazard

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Features of debt contracts that reduce moral-hazard problems:

• Restrictive covenants• Collateral requirements• Net worth requirements• Reputation (a form of collateral or net worth)

Asymmetric-Information Costs: Moral Hazard

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Catalysts in Financial Markets

Δ Technology

Δ Shape of financialintermediaries and markets

Economic and Political “Shocks”

Δ Transactions CostsΔ Information Costs

Δ Relative Return from Granting Rents

Δ Taxation and Regulation

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Catalysts in Financial Markets

Technological improvements:• Advances in finance and statistical theory• Advances in computing speed, power, and

storage space• Advances in transportation and

telecommunication

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Regulation of Financial Markets

Justification (according to your text):1. Increase Information to Investors

• Decreases adverse selection and moral hazard problems

2. Ensuring the Soundness of Financial Intermediaries• Chartering, reporting requirements, restrictions on assets and

activities, deposit insurance, and anti-competition measures.

3. Improving Monetary Control• Reserve requirements

• Deposit insurance Market failure!

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Two better reasons:1. Hysterical political reaction to real or

perceived crisis

2. “Rent” seeking– Use of government power to secure return

above opportunity cost (economic rents)

Regulation of Financial Markets

Technological and political/economic shocks alter the returns to taxing and regulating.

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Example of hysterical political reaction to real or perceived crisis plus rent seeking:

Glass-Steagall (1933):• Established firewall between investment and

commercial banking.• Based on idea that investment banking would

increase risk of commercial banking and that potential conflict of interest existed.

Regulation of Financial MarketsGlass-Steagall Act (1933)

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Regulation of Financial MarketsGlass-Steagall Act (1933)

But...• Portfolio theory indicates that combining commercial and

investment banking actually reduces risk.

• Evidence from 1920s indicates that bonds underwritten by investment bank subs of commercial banks performed well (no evidence of massive fraud).

• Public benefits from economies of scope available by

combining commercial and investment banking.

Mistake not fixed until 1999!

Questions over

Modigliani-Miller and

Financial Structure?