On the Modigliani-Miller Propositions

After receiving valuable comments from my recent post “Modigliani-Miller theorem: did you
know that there was a Proposition III?” I’d like to add some clarifications about the role of the
assumptions in economic theory and how MM theorem can help practitioners.

Misinterpretation of Proposition III can be avoided by remembering that it states that the
minimum expected rate of return required for a project to be just worth doing, is a property of
the project and its risk, and not of the particular securities that happen to be used to finance it.
This that not mean that the senior management have no preferences for one type of financing
or that there are local conditions, real options or other issues which influence the decisions.
However, many of these issues does not change the principal concern: for investment
decisions, the relevant cost of capital continue being the marginal cost of capital.

When I explain MM theorem to the audience, I first explain why in a world without corporate
taxes the capital structure is irrelevant, and then explain that it is important to consider
corporate taxes. When trying to cover the myriad of details, I feel that we explain only the
movement of the hands of the complex, splendid Swiss watch that the MM theorem really is. It
can be expanded in a numerous ways. In other words, the theory supports different contexts
of analysis and can be taught in different formats, in more abstraction for the school of
economics and in less abstraction for the school of business, without loss of precision. And it
can be perfectly integrated with the CAPM and the option theory.

MM theorem has certain implications, which are perceived as “strange” the first time you read
the paper. For example, Proposition III implies that the cost of capital is not affected by the
cost of debt, and Proposition II implies that if the cost of debt increases as the firm is
leveraged, the cost of equity decreases. And it must be, or the arbitrage would force the
process. MM works under certain assumptions and in this specific framework it is impregnable.

Although MM theorem is recognized as building the foundations of a theory of firm valuation

in a world of uncertainty, it is common to hear that these propositions do not hold in the real
world. Moreover, some profanes believe that MM Propositions are not “true”. As a
practitioner, I believe in an optimal capital structure but I always say that if you really want to
know about valuation and corporate finance, MM theorem provides excellent bases. Probably
MM is the “center of gravity of finance theory” and of course, the other cornerstones,
portfolio theory, the CAPM, the efficient capital markets hypothesis and Black & Scholes
formula are “distributed” around this center of gravity. Regarding the truth of MM
Propositions, I would prefer to reproduce a dialogue that took place during a deposition in a
law suit between Merton Miller and the attorney of the other side:

Attorney: Professor. Do you or do you not believe that the M&M Propositions are true?

Merton Miller: Those Propositions were conditional propositions. They say that if you accept
the specific assumptions we made about the nature of the capital markets, then you must
accept the conclusions. The M&M Propositions follow logically from the assumptions and in
that sense they are certainly true.

Attorney: “but what if the assumptions underlying the derivatives are false? Doesn’t that mean
that the M&M Propositions are false?
Merton Miller: “You still do not seem to understand the principles of scientific inquiry. The
minute you are questioning the assumptions underlying the model you leave the world of pure
logic behind. You have gone from deduction to induction, from an ideal world to the empirical
world where terms like true and false no longer apply. On empirical matters, you cannot speak
of anything as simple as right or wrong, but only of the degree of accuracy of the predictions of
the model. And for judging the accuracy of the predictions, the literal accuracy of the
assumptions is beside the point. It all comes down to the question of “goodness of fit” and that
alas cannot be given any simple, one word or even one line answer. How good a fit is depends
on the specific context and on the specific purpose in asking the question.”

How MM helps us in practice

Up to here, many skeptics would agree that the MM is a robust theory, but believe that it
belongs to the realm of “blackboard economics”, where there is little correspondence between
the theory and the real world. However, MM theorem is also useful in practice. By the way, do
you think that practitioners know that the extensively used in practice Hamada’s formulas for
levering and unlevering betas requires all the assumptions of the CAPM and of the MM model
with taxes?

This is not surprising, since there is nothing more practical than a good theory. Let me talk
about what happened in a meeting with one of the partners of Sofora Group in 2008, when we
were hired to determine the fair value of Sofora, which is the owner of Telecom Argentina. We
almost had finished the analysis, which took a considerable time. In the meeting I explained
how we had obtained the fair value of Telecom, and the expected dividend policy, since before
the Sofora’s common shareholders received their dividends, preferred shareholders should
receive their dividends first. Our methodology consisted in calculating the DCF value of
Telecom first, then adding a control premium and finally subtracting the fair value of preferred
shareholders, which was obtained by discounting the forecasted dividends, to achieve the
Sofora Fair Value:

Valuation of Sofora (in U.S.$ millions)

Telecom Argentina fair value 4.502,1

Nortel Inversora particip. (54,74%) 2.464,5

Control Premium 492,9

Preferred shareholders class A fair value 282,0

Preferred shareholders class B fair value 1.047,8

Sofora's shareholders fair value 1.627,6

Suddenly, one of the board members, R.M., asked me: “if you calculate the discounted value
of Sofora’s shareholders’ forecasted dividends it should be identic to the fair value, isn’t it?

The equivalence was evident and I said immediately “yes” (what I didn’t know at this moment
was that the same question had been made to one of the other hired consultant firms and
they couldn’t justify the difference). “The whole is equal to the sum of its parts”, I thought. “In
MM with and without taxes the whole is always equal to the sum of its parts”, I said myself.
The anecdote about the pizza story came immediately to my mind. “It’s after the football game
when the pizza man comes up to Yogi Berra saying: “How do you want me to cut this pizza,
into quarters? No, cut it in eight pieces, I feel very hungry tonight”. 1 With my notebook in the
meeting, I began to perform the calculations, uncomfortable before the inquisitor faces of the
other board members. The difference was about US 293 million (or, in another way, a
ridiculous discount rate of 5% was necessary for the two approaches to match). I asked for
more time to perform the analysis. I thought: “might I have lost any part on the way?” After
looking here and there, I remembered that when we performed the valuation of Telecom, we
considered that all of forecasted free cash flow would be distributed as dividends to
shareholders, as is usual in practice. We handled the “problem” considering the difference as
“excess marketable securities”, because investments in marketable securities have zero net
present value and there is no effect on the value of the company as the theory of finance
learnedly postulates.

After revising the analysis, we noted that to calculate the fair value of the preferred
shareholders portion we considered the historical payout of Telecom, therefore, they did not
consider that all free cash flow would be distributed as dividends as in the case of Telecom fair
value. Nevertheless, if the “excess marketable securities” belonged to the Telecom
shareholders, a portion of them also would belong to the preferred and common
shareholders. Therefore, we made a second analysis adding the present value of marketable
securities to the Sofora DCF. When both excess forecasted marketable securities and the
securities that Telecom had at this moment were added, both approaches matched and all of
us became satisfied with the double check.2
Valuation of Sofora (in U.S.$ millions)

Sofora DCF 841

PV marketable securities 217

Marketable securities at Dec 2007 83,47

Control Premium 492,9

Sofora's shareholders fair value 1.635,26

For a more professional discussion, a brief review of the Sofora valuation (in Spanish) can be
found here

About the different approaches to estimate the capital structure on valuation click here

1
Merton H. Miller, from his testimony in Glendale Federal Bank´s lawsuit against the U.S. government,
December 1997.
2
A minimum difference persist due to the different dates for the dividend distribution.