Modigliani and Miller
The Modigliani and Miller theorem set conditions for effective arbitrage. As an example, when a financial market is not consummated by taxes, transaction cost, bankruptcy costs, and misguided information or any other errors committed which limits the access to credit, and then investors can, without any cost, replicate a company’s financial actions. This gives investors to influence the company not to implement any unyielding decisions, if they so desire. Attempts to overturn the Theorem’s controversial irrelevance result were a fortiori arguments about which of the assumptions to reject or amend.
The systematic analysis of these assumptions led to an expansion of the frontiers of economics and finance. The weighted average cost of capital bears no relation to the ratio of debt to equity. Leverage increases the expected return to shareholders but also makes the shares riskier because of the earnings that must be earmarked to pay interest on the debt. For every amount of additional debt a company takes on, equity investors will demand a higher return on their shares to compensate for the extra risk of bankruptcy (Levinsohn, Alan.
Modigliani and Miller live on. Strategic Finance. 2003) Dividend policy is irrelevant. It makes no difference to investors whether a company pays out all of its profits, some, or none to shareholders. A company’s capital investments compete with dividends. Cash paid in dividends must be replaced with debt or equity, they reasoned. The share price will fall by exactly the amount of the cash dividend. Paying dividends resolve influence how a company finances its growth but won’t have a lasting effect on its value in the marketplace. Question 2.
Outline the key characteristics of the case that dividend policy is irrelevant to the determination of shareholder wealth, and critically assess the validity of the claim in relation to the argument that signaling and clientele considerations severely compromise the status of the irrelevance model. Capital Markets are perfect. Markets are frictionless (there is no transaction cost), no taxes, and all assets are perfectly divisible and marketable (it is not divisible and it can’t be owned as an asset), and there are no constraining regulations. There is a perfect competition with regards to product and securities markets.
Among other things, this implies that all producers and consumers are price takers. That is, information is costless, and is received simultaneously by all individuals, both corporate insiders and outsiders (this implies no signaling). Agents are perfectly rational and use it to maximize there utility. • There is no cost with regards to bankruptcy. • The firm issues a risky debt and equity and has the same beta b risk. • All cash flow streams are perpetuities and no growth is allowed. • Allowing for proportional corporate tax eases the “no-tax” assumption. • Managers always maximize the shareholders’ wealth.
• Homemade leverage is a perfect substitute for corporate leverage. That is, there is no difference between corporate and personal borrowing. Question 3. Discuss the following statement: Once agency costs and bankruptcy costs are incorporated into Modigliani and Miller analysis of the effects of financial gearing on the value of the firm, the conclusions are strikingly similar to those of the traditional view of the financing decision. Agency costs are those that restrict the leverage and debt maturity and on the other hand increase yield spreads, but their importance is relatively small for the range of environments considered.
When there is bankruptcy cost corresponding to the over exposure of a certain company, a leveraged firm may amend its strategic choices in order to decrease its probability of bankruptcy. When the capacity level of the inflexible technology is small, debt may encourage firms to choose less flexible technologies. Debt may be used in a strategic way. We show that debt can be used as a partial collusion tool to increase the expected profits of both firms. We show also that a firm may use debt as a commitment device to increase its own expected profit to the detriment of its rival.
The results from the two (2) costs suggests that there will be difference in inputs/outputs and at the same time arrive at different conclusions; thus, it may not be appropriate to use only one approach and base conclusions on that, hence both approaches should be used to effectively measure the accuracy of the methods. The value-added approach provides insights into the technical efficiency and cost efficiency of different organizations, but the financial intermediary approach provides insight into efficiency based on return on assets and financial condition. Question 4.
Discuss the claim that the Modigliani and Miller analysis of the effects of financial gearing on the value of the firm, rather than overturning the traditional view, merely codifies its claims in a more rigorous and consistent fashion. The Modigliani-Miller analysis suggests that investors should have different mindset towards the company’s capital structure especially if the company is minimizing its cost of capital. In other words, there should be no peculiarity to be drawn against a company that has high levels of debt and to another one that holds no debt with other financial institutions.
However, in the real world, things are different. Gearing does, if nothing else, affect investor sentiment. When times are tough, highly geared companies are seen as vulnerable. They may see their stock market rating and credit ratings suffer, and find it harder and more costly to borrow. It is also likely that an exaggerated measure of the actual cost of a debt and at the same time an aggregate measure of the real cost of equity may influence the firms’ gearing decisions. In equilibrium, the cost of debt, plus some risk premium, should be equal to the cost of equity.
However, in equilibrium conditions, a company may not hold continuously of the gearing. If this is the case, and if the deviations in the relative real cost of debt are not just firm-specific, then this factor may influence managers’ gearing decisions. When the real cost of debt rises relative to the real cost of equity, firms can be expected to increase their gearing. The Modigliani and Miller theorem also showed that the overall cost of capital for the company is independent or does not get affected by the debt-equity ratio.
Changing a firm’s gearing would create no value. What mattered was how the firm executed its operations — for maximum profit. Question 5. Discuss the extent to which the idea of synergy gains provides an adequate framework for understanding the motives behind mergers and acquisitions. Explain and comment upon at least to alternative perspectives on merger activity in your discussion. Traditionally, synergy studies in Mergers and Acquisition context have focused on two critical aspects of synergy, both the financial and operational.
Operating synergy or operating economies may be involved in horizontal or vertical mergers and both of which create economies of scale. Merger announcements can reveal information about both synergies and stand-alone values of the merging firms. Synergy gains, on the other hand, are significantly positive for focused mergers and are higher compared to diversifying mergers. Synergy gains are usually on a statistically insignificant method. Also document that merger gains arise primarily from operating sources such as reductions in capital spending and working capital investments, rather than financial synergies.
The most desired motivation has been achieving significant economies of scale or operating synergy. The industry is expected to significantly consolidate in the future. The existence of synergies can be determined by examining changes in the equity market values and target firms are not an easy task. Specifically, the change in equity market value around merger announcements could be due to synergies and information revealed by the merger announcement about the stand-alone value of the merging firms.
Furthermore, the stock market could capitalize the expected value of a merger before the formal merger announcement, making it difficult to accurately value merger benefits using announcement period stock returns. The mean financial synergies for are both insignificant for the totality of the sample and for friendly mergers. Moreover, we find that diversifying mergers are expected to create value due to higher interest tax shield, probably since diversification would reduce cash flow volatility and increase debt capacity.Sample Essay of Custom-Writing