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The author at The Cardinal Collective in a related article titled ModiglianiMiller In One Easy Lesson writes:
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Ashish writes:
For limited liability corporations, it will be better to issue debt than equity. In first example you cited, if the firm decided to finance the telecom infrastructure project with a $5 billion in equity and $5 billion through debt, then shareholders will lose only $5 billion. Posted August 1, 2005 10:09 AM
Arnold Kling writes:
Ashish, it is correct that if the firm has 0 net worth to begin with, then limited liability will mean that issuing $5 billion of debt would put a lot of the burden of a failed project on the debtholders. However, it is wrong to say that therefore it would be "better" for shareholders to issue debt. Bondholders are not stupid. They charge a higher interest rate to compensate for the probability of default. The more levered the firm and the riskier the underlying projects, the higher the interest rate. Posted August 1, 2005 10:35 AM
Ian Lewis writes:
I hope I am not being nitpicky, but are you sure that it is a "theorem"? As far as I understood, Theorems only existed in Mathematics and nowhere else. I understand that ModiglianiMiller uses mathematics, but it is an Economical Theory. No? Just curious. Posted August 1, 2005 1:53 PM
Patrick Tehan writes:
I don't think MM said it was essentially irrelevant because they stated it's only irrelevant in a world based on assumptions we know aren't true (for instance no taxes). Since we know there are taxes (and tax shields), the fact that firms aren't financed completely with debt means that financing is relevant with regards to bankruptcy and agency costs. Posted August 1, 2005 2:05 PM
dsquared writes:
Ian: The MM Theorem is a theorem, proved over a set of axioms. The economic theory is the assertion that the MM Theorem accurately models dividend policy. Posted August 2, 2005 2:30 AM
dsquared writes:
Btw, Arnold, I think that this is quite a confusing way to present the MM result and the first paragraph quoted above is a mistake. Highly levered firms *do* have higher expected returns and higher risks (to their shareholders) than less levered firms. The MM result is that the risks exactly offset the returns and that firm equity value is invariant to leverage. Investors *can* change the riskreturn profile of their investment by choosing a level of leverage  that's the whole basis of MM  the theorem just proves that they don't get a free lunch by doing so. Posted August 2, 2005 2:34 AM
Arnold Kling writes:
Dsquared, You're right that it would be better to talk about the invariance of firm value relative to how the cash flows are carved up. Posted August 2, 2005 7:50 AM
Ian Lewis writes:
Hi dsquared, TIA Posted August 2, 2005 9:19 AM
Lauren Landsburg writes:
For a few more explanations of ModiglianiMiller, see these articles in Concise Encyclopedia of Economics, David R. Henderson, ed.: Biography of Merton Miller Posted August 2, 2005 1:29 PM
dsquared writes:
Ian; it's a mathematical theorem; specifically, what you do is prove using the normal mathematical methods, that the solution to a particular optimisation problem is invariant to one of its parameters, under various axioms. You then make the economic argument that the optimisation problem is usefully analogous to the problem of valuing a firm, the axioms are a reasonable description of how a company generates cash flows and the invariant parameter is analogous to "leverage". This is how mathematical economics is done and in my opinion the analogies are usually not terribly good. Posted August 3, 2005 11:00 AM
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