Are Modigliani and Millar right?

In 1958 Modigliani and Millar came up with this great proposition that the market value of a company is independent from its capital structure. And thus capital structure has no impact on WACC.

Modigliani and Millar are clearly very clever guys so why in 1958 did they leave taxation out of their work? They clearly knew that all countries change some type of corporation tax. Not only did they presume there is no taxation amongst other things they also said there are perfect capital markets. These things clearly didn’t help prove if their theory would work in the real world.

Unsurprisingly they revisited their findings and changed it in 1963, but yet the only change they made was add taxation. However by only this small difference by adding tax led to Modigliani and Millar theory changing dramatically! Because debt is a tax-deductible expense, which can be offset against profits; thus increasing debt decreases WACC but increases shareholder wealth. Furthermore in the 1963 theory it then goes on to state that to deal with an increasing WACC a company should become highly geared.

This is where my levelheaded mind kicks in as increasing and increasing a company’s debt doesn’t sit well with me. Surely there becomes a point if a company is doing this where they can’t pay the debt installments and don’t have any more assets to put against a loan. Higher levels of debt to equity increase the likely hood of bankruptcy!! Which surely would lower the value of the business? If I were a shareholder in that company I would be running for the hills or they would have to prove to me it is worth staying with a greater rate of return.

The examples are endless of businesses following M&M’s theory of increasing their debt didn’t work out well for them.

Firstly Samson missed its debt payment last August, which lead to the company declaring themselves bankrupt after racking up $3.25 billion in debt. Understandably being in the oil business Samson would have a certain level of debt with the oil industry having extremely high costs. But acquiring the amount of debt they had meant when the oil and gas prices dropped, profit reduced and they couldn’t pay their debt payments. They then had to put forth a plan that would hand equity in the restricted company to junior leaders who in return would forgive the $1 billion in debt they hold.

Another company from last year is American Apparel a successful company but again ran up debts and it went wrong to the point where their shares crashed and they have had to file bankruptcy. The company has had to agree to sell off $200million to their creditors in a debt to equity swap.

Other examples include AIG debt leading to the getting bailed out, Afren who defaulted on payments and the documentary RBS: Inside the Bank that ran out of money says it all again. A business has to have a rainy day fund; you need cash in the bank!!

I understand that debt is a good way to finance a business and having a reasonable amount of debt that a business can keep on top of is good. For the life of me I just don’t see why a business would want to pile the debt on themselves to follow M&M’s theory which has too many assumptions.

After writing this article though I am left with one question what is a reasonable amount of debt for a business?

Thank you for reading; please feel free to write any comments

Lehman Brothers: the scapegoat?

At 14 years old when the banking crisis took place and still today I struggled to understand the amount of money lost in the crisis and how an industry as important as this was allowed to fail.

The last days of Lehman Brothers gives an understanding of some of the things that took place within the banking crisis including bankruptcies and bailouts. Before discussing Lehman Brother’s case it seems ludicrous to me that it was even possible for the banks to get into this crisis where the governments where bailing out billions of dollars and people’s lives were getting ruined. Did the banks just not realise the mess they were in until it was too late? Or did the think they were unbeatable?

The root cause of this problem starting with the banks giving mortgages to people that couldn’t afford to pay it back. Everyone was ruled by greed; the CEO’s wanted more money, bankers wanted bigger bonus and people wanted bigger and bigger houses. This went on for years; now the main concern is have the governments regulated this industry to stop a repeat like this occurring.

After watching the documentary about the collapse of Lehman, I was left with two questions how was the world’s largest bankruptcy of $691 billion allowed to happen? And why was Lehman Brothers the only major US bank that wasn’t saved by the US government?

Six months before Lehman’s collapse Bear Stearns found themselves in a similar situation to which the Fed intervened by assuming $29 billion of losses. Two days after Lehman’s bankruptcy the US government bailed out AIG with a package costing $182 billion!!!!!  Showing the Fed possessed the funds to aid Lehman’s survival. I acknowledge that the failure of AIG would have had a greater global effect damaging economies not only in North America but Europe and Asia. But still why not aid for Lehman?

The Fed have never provided evidence for their decision that Lehman was insolvent stating there was “no time” that weekend for a written analysis. However the main reason given by others for the failure of Lehman is the mess they had put themselves into through risky real estate investments and over estimation of assets; this left them with $25 million of bad debts as stated in the documentary. This debt was the main reason both the Bank of America and Barclays acquisitions of Lehman fell through.

Through research the main factual difference I can find between Lehman and the other two banks is their problem was a short term cash issue which once it was cleared they could carry on operating; as Lehman’s had a long term debt issues. However I don’t believe this was the main reason they received no fed funding.

Alan S. Blinder and many others have stated that the decision to not save Lehman Brothers and thus their demise was the cataclysmic event to the entire crisis. I believe Lehman was left to fail; to be made an example of for the rest of the financial industry on how not to do business so recklessly. Thus in that respect it worked as 8 years on people are still debating ‘The Weekend That Wall Street Died’.  The one question we will never know the answer to is if Paulson (US treasury secretary) knew the extent that the aftermath of Lehman’s bankruptcy had on the world economy; would he have stopped Lehman Brothers collapsing?

I would love to hear anyone else’s opinion for why the US Federal Reserve left Lehman to fail?

Even the queen’s at it!

Whilst studying my GCSE’s I took part in the stock market challenge which involved schools all across the UK competing against the market and against the other teams to earn the best return on their investment. I naturally invested my money into companies that were doing well following the past market trends believing that I was bound to be successful because I wasn’t making any stupid decisions. So how did the group that won the trip to New York win?

I put it down to luck investing in risky companies could have led to their investment going either way because you can’t predict that a struggling companies shares would suddenly be successful. Kendal found that prices changed in a random fashion and there is no link between one share price and the next. I knew this and so believing it was down to luck I went for low risk companies but received low return.

So this lead to my next question how can I get guaranteed high returns with low risk? This is a question I never really knew the answer to until my lecture on portfolio theory. Portfolio theory was developed in 1952 by Markowitz and in simple terms it suggests investors can reduce risk by diversification and holding a portfolio of investments.

An example of how this works can go back to the banking crisis if you had invested in Lloyds bank shares in 2007 there were around the price of 434.48 GBX a share and 2 years later the price dropped to 21.97 GBX. Leading to a huge loss for an investor; at the same time investing in gold from 2007 to 2011 you would have tripled your money. Having both of theses in your portfolio the gold price would have helped cancel out the loses made with the Lloyds shares. In one of the articles I read in my seminar many economists including the creator of this theory say the importance of diversifying into a number of areas.

Even good old Lizzy is at it? Granted the Queen will have the best advisors sorting her investment portfolio which includes art, property, UK bonds and equities. These have all been good investments; the price of older houses in the UK matched the capital value of shares (not including dividends). However a lot of the queens investments are expensive to manage and harder to trade (not many people are going to buy a 3000 carat diamond). This has led to the monarchy starting to diversify by including foreign assets and shares. 

Should you do this too? In my opinion to have a diverse portfolio means it is necessary to go international; as for a portfolio to reduce the risk of an investment the correlation between investments cannot be positive. This means that you need to invest in things that won’t be affected by each other so the broader your portfolio the better.

Maybe if I had known about portfolio theory when I did the stock market challenge I would invested in a greater range of companies and I'd have been the one that won the trip to New York.

Having an international portfolio is necessary to guarantee returns; the queen has started to do this and I think you should too!  Don’t leave it down to luck.

Thank you for reading, any comments are greatly appreciated