Video"The M&M propositions remind us that it is corporate strategy that produces value," says Cheryl Francis, CFO of R.R. Donnelley & Sons Co., a Chicago-based commercial printer. "The challenge on the right-hand side of the balance sheet is to find the capital structure that can support the business strategy. What M&M does is help you cut through the smoke and mirrors, the marketing pitches, and find the true value-creating opportunity."
In a slow-growth business like printing, one might expect a conservative balance sheet. But what about a fast-growing company?
"Right now the dominant and overwhelming consideration is making sure that our capital structure and the amount of cash on the balance sheet are sufficient to provide us with the operating and strategic flexibility at this very important time in Internet commerce," says Joy Covey, CFO of virtual bookseller Amazon.com, in Seattle. "How many market-share points we have at the end of the day and how many customers we have--and how happy those customers are with our service and our product offerings--are by far the most significant drivers of shareholder value for us."
How about high-tech businesses? Same story.
"I would very much agree with the premise as it is stated: total firm value is independent of the capital structure," says Bill Daniher, CFO of a division of AMP Inc., an electronic- connector firm in Santa Clara, California. Daniher, 36, remembers studying the propositions in business school. "The value of the firm is much more dependent on the value of its products and services, its underlying technology, and its market position--all of the things on the left-hand side of the balance sheet," he says. "That's where I'd look for firm value, as opposed to how it is financed."
Such beliefs were echoed in a 1989 study done by J. Michael Pinegar, a professor at the Marriott School of Management at Brigham Young University. Pinegar asked the Fortune 500 CFOs to rank the most important variables that influenced their capital-structure decisions.
"The things that are emphasized in some of the post-M&M financial literature, such as the tax deductibility of interest expense and bankruptcy costs, did not come up big for the managers who responded to our survey," Pinegar says. "The things that turned out to be more important were the connections between the financing and the asset that needed to be financed, the risk of the cash flows that the asset would generate, and the expected return on the cash flows."
Which is music to the ears of one Merton Miller.
"What I draw from the debate is actually the robustness of the original propositions," he says. "Sure, they are not literally true, and there can be little nits here and there." But, he adds, the experience of the last 40 years has convinced him "there is not much easy systematic gain from leverage, other than taxes--which we don't know too much about."
----------------------------------------------- --------------------------------- Three Propositions That Changed Finance
Modigliani and Miller were able to say the surprising things they did about debt and equity because they took the corporate balance sheet out of the hurly-burly of the marketplace and brought it into the economist's laboratory. In this somewhat sterile setting--where there were no taxes or transaction costs, such as bankers' and lawyers' fees, and where managers didn't behave differently under different balance- sheet scenarios--things looked a little bit different.
The original M&M propositions consisted of three closely related points:
Proposition I. The value of a company is dictated first by the earning power and riskiness of its assets, not by how those assets are financed. In their paper, the authors gave the following analogy: No matter how hard he tries, a dairy farmer can't increase the value of his milk by selling the cream on the top separately from the milk on the bottom. What he gains in price when selling the cream, he'll lose in price when selling the milk.
Proposition II. The cost of equity capital is an increasing function of leverage. That means you can't lower your total cost of capital by issuing "cheaper" debt. Why not? Although debt may cost less, it also, in the market's eyes, increases the riskiness of your stock and hence your cost of equity. In short, there is no such thing as a free lunch. In M&M's words: "The gains from being able to tap cheap, borrowed funds are more than offset for stockholders by the market's discounting of the stock for the added leverage assumed."
Proposition III. In the authors' words, "[T]he type of instrument used to finance an investment is irrelevant to the question of whether or not the investment is worthwhile." Having shown capital structure to be irrelevant for the company as a whole, M&M then extends irrelevance to the individual investment. In M&M's ideal world, issuing debt to finance a new plant won't make it a more profitable investment than issuing equity.
The Dividend Propositions
As if these propositions were not enough, Modigliani and Miller stirred the pot again three years later. Their paper "Dividend Policy, Growth, and the Valuation of Shares" spelled out what have come to be known as the dividend propositions. In a perfect market, once they have chosen their investment policy, managers cannot increase the value of their firm by paying out a higher dividend. This is because if they pay out a dollar more in dividends, the firm is worth a dollar less, or it has to raise a dollar with more securities. As one observer put it, this insight put the authors on the "radical left" at the time, since it implied that firms need not dole out more dividends to institutional shareholders.
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