Untaxing-II (Modigliani-Miller) ch 7: Lemma Proof Implications
The Modigliani-Miller theorem states that it makes no difference if the public company uses debt or equity to finance itself. But it is crystal clear that an equity investment produces a $66.66 million market value and a debt loan produces a $31.66 million market value which is a suppression of $35 million in market value.
Fortunately we may now use this lemma proof by way of a thought experiment to counter-argue with economists and CFOs who rely on the Modigliani–Miller theorem to justify using debt. It proves there is absolutely nothing irrelevant about a public company naively taking on debt (to finance operations), and, in fact, debt is an attack on current and future earnings and a suppression of the public company’s market value.
The reason that the public company in the above thought experiment is only worth $31.66 million instead of $66.66 million is because the $1 million in debt was paid back out of the $2 million in revenue, leaving $950,000 for earnings to be divided by 0.03 instead of $2 million in earnings being divided by 0.03.
Notice the power of equity over debt when the $35 million in lost market value (caused by reducing profits) is related to the $1 million debt loan decision!
Note the investor’s lost opportunity by comparing the $50,000 of interest created from a $1 million deposit with a 5% ownership interest worth $3.33 million in the public company. The comparison here is similar to the one in chapter one when debt was compared with equity. In this case, equity is 46.6 times more powerful than debt. The return to the investor is $3.33 million in equity value minus the $1 million investment. The $2.33 return is 4,560% greater than the $50,000 interest created from the investor’s bank deposit. It’s a big loss for the investor.
The essence of this white paper is that anything that attacks a public company’s profits — be it a debt-loan or taxing the public companies profits instead of taxing equity — does more harm than good to the United States of America. This will be demonstrated next.