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