[scientizscht (OP)]

Hello

I do not see a social sciences forum so I post here.

In the MM proposition for no taxes, when you increase the leverage, does the value of equity decrease?

Thanks

[evan_au]

the Modigliani Miller proposition

For those who (like me) are not aware of this theory in economics, you can find out more here:
https://en.wikipedia.org/wiki/Modigliani%E2%80%93Miller_theorem

A Nobel prize in economics was awarded for this work, so it must have impressed some economists.

In the MM proposition for no taxes, when you increase the leverage, does the value of equity decrease?

After a quick skim, it seems to me that the "value of equity" (ie how the stock market values the company) will not change when you increase the leverage (finance by selling stock) or increase the debt (finance by borrowing).

Of course, this assumes that:
- The stock market is rational: in fact we know that it quite often functions on rumours, group think and testosterone
- There are no taxes: this may sound attractive to billionaires, but we know that taxes (and fairly distributing the proceeds of taxes) is vital for a healthy, prosperous  and peaceful society

[alancalverd]

Beats me how the MM hypothesis could be worthy of a primary school prize for neat writing, never mind a Nobel prize. The argument seems entirely circular, that if an entity is worth X, its value is X.

Fact is that if a company borrows money in the real world, that loan is either guaranteed seniority over all other payments; or renegotiable at a penalty rate of interest, or secured on an asset that can be sold for more than the residual value of the loan, in the event that the agreed repayments and interest cannot be met. Thus when valuing the entire company for purchase, loans are an encumbrance but equity is not. The usual takeover investment for a small company is to buy at least a majority of voting shares and pay down a substantial part of any senior loans, in order to maximise future dividends.

Been there, made (through loans) and lost (through shares) money on it.

[scientizscht (OP)]

Let's say you have a specific company with specific assets worth of e.g. 100.
Then you assume this company is financed through equity only and alternatively through equity and debt.
The total value of the company will still be the same 100.
And we know that D+E=V, so that if there is no debt, then the equity must equal 100.
But if there is debt, the equity will be equal to V-D or 100-D which is something lower than 100.

As a result, I understand that the equity of the company will worth less, unless the total value of the company changes but this would violate MM proposition I so it is not the case.

[alancalverd]

Company A with 100 of assets that owes the bank 100 is a hiding-to-nothing  gamble. If it doesn't make a profit in the next accounting period, the bank will seize its assets or increase its debt liability. 

Company B with 100 equity shares and no debts is a fair bet. If it doesn't make a profit in the next quarter, I'll still own the assets.

The only exceptional case is if I buy the entire debt of A, or all the shares of B. In either case I'll end up with 100 assets. This is simple mathematical degeneracy, and I still don't see how the bloody obvious is worth a Nobel prize! 

The Wikipedia entry is illuminating   

Despite limited prior experience in corporate finance, Miller and Modigliani were assigned to teach the subject to current business students.

Degenerate solutions in an ideal (no tax) world lies in the realm of theoretical physics, not business finance. Sadly, I think I once appointed a board of Chicago graduates and ended up flushing fivers down the toilet because it was more fun and just as profitable.

I agree with Donald Trump (or at least his father) on one  matter: if you've never been bankrupt, you know nothing about business.

[Bored chemist]

We are all born bankrupt.

The argument seems entirely circular, that if an entity is worth X, its value is X.

Actually the whole point of the  exercise is that x is not x
"However, if we move to a world where there are taxes, when the interest on debt is tax-deductible, and ignoring other frictions, the value of the company increases in proportion to the amount of debt used"

Which strengthens my belief that  economics only exists to make astrology look credible.
As far as I can tell the interesting bit is this "when the interest on debt is tax-deductible".

i.e. when the government decides to give some of the taxpayers' money to the company.
In which case "the value of the company increases in proportion to the amount of debt used" is as true (and as obvious) as AC pointed out.

[alancalverd]

"Ignoring other frictions". Love it. Theoretical physics at its best.