Untaxing-II (Modigliani-Miller) ch 6:     Debt and Equity Financing Affect Market Value Differently

part II            [previous]            [next]            part III

It is necessary to do a lemma proof and invalidate the Capital Structure Irrelevance Principle. Let’s examine the Modigliani-Miller theorem rationale using a “thought experiment” (popularized by Albert Einstein) to support the conclusion of the Debt-Equity comparison illustrated in Table 1 of chapter one.

We have three entities: an investor, a bank and a public company. The investor has $1 million. The bank wants the investor to deposit this $1 million at the bank for 5% interest. The new public company has a hot product and desperately needs a $1 million cash infusion.

If the investor deposits the $1 million in the bank for one year at 5%, he or she will have made $50,000 ($1 million times 0.05) at the end of the year. If, instead, the investor decides to purchase 5% of this hot new public company for $1 million, merely by taking the risk of buying 5% of this hot new public company, this new public company’s valuation is $20 million (= $1 million ÷ 0.05).

(Now some of the readers will not believe this instant $20 million valuation fact due to their having been negatively influenced daily by credit-interest-debt. But let me bring the doubting reader’s attention to a real life example: Microsoft purchased a piece of FaceBook long before FaceBook was known by the general public. Using a simple valuation standard, Microsoft bought 1.6% of FaceBook for $240 million. This simple transaction made FaceBook instantly worth $15 billion (= $240,000,000 ÷ 0.016).

Our public company now has a $20 million valuation and $1 million cash to pay for its operations. Note that the $1 million need not be paid back. This is the first result of a “positive-equity” investment.

Now suppose this new public company works hard in the first year using the $1 million investment and makes $2 million. The $2 million is declared as dividends when the dividend yield is 3%.

This $2 million in dividends is now divided by the 3% dividend yield, making this public company worth $66.66 million and increasing the investor’s net-worth by $3.33 million (the $1M investment got the investor a 5% ownership interest in the company or 5% of $66.66 million). This is the second result of using “positive-equity” to finance the public company. The return on investment is ($66.66M – $1M) ÷ $1M which is 6,566%.

OK, now suppose that instead of investing the $1 million, our “investor safely and fearfully deposits this money in an interest-bearing savings account and the hot new company borrows the $1 million it needs from this bank at a 5% rate of interest. This is a “negative-debt” loan.

Why is taking a bank loan characterized as being negative? The numbers answer this question. The principal amount of the loan plus interest accrued must be subtracted from the company’s $2 million revenue. Taking the $1 million principal and $50,000 in interest from the revenue leaves the company with $950,000 which is declared as dividends when the dividend yield is 3%.

Instead of $66.66 million, the hot public company’s market value is $31.67 million, the result of using “negative debt” to finance the company’s operations. This huge difference of $35 million illustrates the suppression of the company’s market value when a bank loan instead of an investment is used to finance operations.

Lemma Proof Conclusion.

What can we conclude by comparing debt and equity financing of the public company? The one qualified conclusion is the Modigliani–Miller theorem, which states that it makes no difference if (negative) debt or (positive) equity is used to finance the public company, is flawed.

There is a profound positive multi-million dollar difference in market value if the public company uses equity instead of debt to finance its operations. It’s clear that a risk-equity investment would produce a market value of $66.66 million and a credit-debt loan would make the company worth $31.66 million. Here are a few more observations:

  • The $1 million debt loan does not produce an immediate $20 million valuation because the funds are borrowed and must be paid back.
  • In contrast, the $1 million equity investment produces an immediate $20 million valuation because the funds from the “risky” investment need not be paid back. Furthermore, the investment helps the company generate $2 million in revenue to produce $66.66 million in equity. Risk is associated with gain.
  • Debt is associated with loss. In using “fearful” debt to safeguard $1 million, the investor missed an opportunity to participate in the equity growth of the company via a 5% ownership interest.

Go to (part II) chapter 7: Lemma Proof Implications

s2Member®