miller modigliani the fate of centrally planned econonomies

7/30/2019 Miller Modigliani the Fate of Centrally Planned Econonomies

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Famous Academic Model. Abused by Central

Planners: Government Bridges to Nowhere

It has often been said that debt doesnt matter in the hallowed halls of Academia. When

considering the finance alternatives to cash vs debt there are many theses which would

suggest that, in a vacuum, capital structure doesnt matter which was popularized many years

ago by an award winning team known as Miller Modigliani. By their own admission, this

famous duo had no actual ideas about corporate finance despite being asked to teach the

subject. They reviewed existing work on the subject, and formed their own theories which

somehow made it to mainstream academia. We present for argument, one of the most widely

used and famous theories in modern finance: The Miller Modigliani Hypothesis!

Debt Doesnt Matter, nor does it affect Capital Structure

In the Miller Modigliani framework, MM hypothesized that capital structure doesnt matter

meaning that if one financed a business with 100% debt or 100% equity that the resulting

business would be the same, since in a vacuum, the aggregate value oftotal investment would

have also been the same. Of course we understand that this is ridiculous in hindsight. People

do incredible stupid things when they spend other peoples money vs their own money. What

about sustainability?

Short Term Thinking

We are far less interested in debating debt as good or evil as a method of funding a business,

and more interested in the conversation regarding behavioral differences between debt

financed companies and equity financed companies. Some would perhaps correctly argue that

some debt is good as it keeps management on its toes, drives for more efficiency, etc.
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whereas too much debt may lead to riskier behavior of managers trying to qualify or remain

within covenants set by their creditors.

What people can generally agree on is that a 100% debt financed business may have far less

value than a 100% equity financed business. Why? Simple. A 100% debt financed business has

the burden of debt, and zero ownership of the company by management in which case theincentive to drive the business is rationally impaired. The only carrot left for management is

that without performance comes the loss of ones job, but theres no other known incentive.

Zero Incentives for Success, Qualification for Stimulus instead of Viability of Franchise

A 100% equity financed business perhaps must, by virtue of its zero debt structure, remain

highly cautious, it will not give away equity to new people since owners are directly tied to the

profitability of the firm, and investment decisions must be much more conservatively made, lest

management throws valuable working capital into investments without proper focus on the

return on those investments. Investment cycles and related return cycles would behaviorally

trend longer vs shorter, and probably take more collective vote since everyones equity

would be directly affected.

Old Models without Modern Significance: Everything Living Dies when Left in a Vaccuum

Modern-day finance and government spending and central planning among governments now

looks much like a highly ingenious if not bastardized version of the famous Miller Modigliani

financial framework. Comparisons are so uncannily similar that it must be seen to be believed.

Modern day politicians in America would content that not only does debt not matter (capital

structure doesnt matter) but also the idea that whomever spends that money, as a second

derivative of MM (Miller Modigliani) also doesnt matter since under this apparently altered

MM framework, who spends the money as a percentage of GDP no longer matters, either.

In fact, if the general public spends the money and invests for growth, thats fine, but if the

government spends the money instead, well then we are calling that equal under the revised

and government imposed MM Framework.

Example American of Chinese Business:

Bob and John create a store which services cars. Change oil, new tires, etc. People hired, jobs

created, and if successful through service to others, Bob and John will open many more stores

and serve more people. Bob and John become wealthy and will, as a service to others, likelyteach others how to do similar business with direct, on the ground knowledge of customers and

trends. Without continuing to listen carefully, the business is always in danger of failure. Bob

and John pay a third of their net profits to the government.

Example Bureaucratic Business, Government Planned:


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Bob and John are hired to run a store which services cars. The store makes money or doesnt

make money; Bob and John keep opening more stores. More people are served, bureaucrats

stop in to see if the stores are kept clean. Government continues to open more stores and while

profitability isnt mandatory, if the business loses cash, it is all to serve the people so its

dismissed as important. The government collects no taxes regardless. There is no incentive to

innovate.

One model is financed with the blood, sweat and tears of its founders who must maintain an

immigrant mindset which is incredibly frugal and responsive to customers, and must remain

highly adaptive to markets lest founders lose what they have created. The borrowed model

with 100% borrowed money (borrowed from taxpayers) is a model without incentive to listen,

without incentive to remain competitive, and without profitability (efficiency) ad a demand

before embarking on expansion. The sociology of these two models is without argument, and

yet with government growing in America from 25% of GDP to its current 35% of GDP we must

wonder. Are the Washington political elite using a 40 year old model of Miller Modigliani to

drive their decision-making despite all evidence that this model only works in a vacuum?

The Sociology of Debt: As outside debt investment or borrowing is used to substitute human

capital, we begin to throw the sustainability argument out the window, no better explained as

the USA borrows more and more money to finance GDP which cannot grow on its own.


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Our model is a model of human history. That model is thousands of years old. That model

states unequivocally that ownership matters and when using borrowed money to finance

ones dreams, equity is impaired. When borrowing 100% of the money for ones dreams,

people lack skin in the game to persist in tough times, leading to mass business failures based

on this same faulty logic. Its much worse than that though..for when an entire country

borrows money to create businesses for which there is no demand, and expects these people

to maintain proper incentive to maintain a franchise.then we are not just one or two but three

steps removed from a reality in which a business would then feel compelled to serve the people.

This process in America is called Stimulus Spending and the process, just like Miller Modigliani,

only works in a vacuum. As in any vacuum, without the oxygen which we will define as

demand by the people we opine that the businessgenerated within this vacuum is

unsustainable; and without this oxygen, business lacks sustainability and must necessarily fail.

References:

Brealey, Richard A.; Myers, Stewart C. (2008) [1981].Principles of CorporateFinance (9th ed.). Boston: McGraw-Hill/Irwin.ISBN978-0-07-340510-0.

Stewart, G. Bennett (1991). The Quest for Value: The EVA management guide.New York: HarperBusiness.ISBN0-88730-418-4.

Modigliani, F.; Miller, M. (1958)."The Cost of Capital, Corporation Finance andthe Theory of Investment".American Economic Review48 (3): 261297.

Modigliani, F.; Miller, M. (1963)."Corporate income taxes and the cost ofcapital: a correction".American Economic Review53 (3): 433443.

Miles, J.; Ezzell, J. (1980)."The weighted average cost of capital, perfect capitalmarkets and project life: a clarification".Journal of Financial and Quantitative

Analysis15: 719730.doi:10.2307/2330405. Ruben D Cohen: An Implication of the Modigliani-Miller Capital Structuring Theorems on

the Relation between Equity and Debt
http://en.wikipedia.org/wiki/International_Standard_Book_Numberhttp://en.wikipedia.org/wiki/International_Standard_Book_Numberhttp://en.wikipedia.org/wiki/Special:BookSources/978-0-07-340510-0http://en.wikipedia.org/wiki/Special:BookSources/978-0-07-340510-0http://en.wikipedia.org/wiki/Special:BookSources/978-0-07-340510-0http://en.wikipedia.org/wiki/International_Standard_Book_Numberhttp://en.wikipedia.org/wiki/International_Standard_Book_Numberhttp://en.wikipedia.org/wiki/Special:BookSources/0-88730-418-4http://en.wikipedia.org/wiki/Special:BookSources/0-88730-418-4http://en.wikipedia.org/wiki/Special:BookSources/0-88730-418-4http://www.jstor.org/stable/1809766http://www.jstor.org/stable/1809766http://www.jstor.org/stable/1809766http://www.jstor.org/stable/1809766http://www.jstor.org/stable/1809167http://www.jstor.org/stable/1809167http://www.jstor.org/stable/1809167http://www.jstor.org/stable/1809167http://www.jstor.org/stable/2330405http://www.jstor.org/stable/2330405http://www.jstor.org/stable/2330405http://www.jstor.org/stable/2330405http://en.wikipedia.org/wiki/Digital_object_identifierhttp://en.wikipedia.org/wiki/Digital_object_identifierhttp://dx.doi.org/10.2307%2F2330405http://dx.doi.org/10.2307%2F2330405http://dx.doi.org/10.2307%2F2330405http://rdcohen.50megs.com/MMabstract.htmhttp://rdcohen.50megs.com/MMabstract.htmhttp://rdcohen.50megs.com/MMabstract.htmhttp://rdcohen.50megs.com/MMabstract.htmhttp://rdcohen.50megs.com/MMabstract.htmhttp://rdcohen.50megs.com/MMabstract.htmhttp://rdcohen.50megs.com/MMabstract.htmhttp://dx.doi.org/10.2307%2F2330405http://en.wikipedia.org/wiki/Digital_object_identifierhttp://www.jstor.org/stable/2330405http://www.jstor.org/stable/2330405http://www.jstor.org/stable/1809167http://www.jstor.org/stable/1809167http://www.jstor.org/stable/1809766http://www.jstor.org/stable/1809766http://en.wikipedia.org/wiki/Special:BookSources/0-88730-418-4http://en.wikipedia.org/wiki/International_Standard_Book_Numberhttp://en.wikipedia.org/wiki/Special:BookSources/978-0-07-340510-0http://en.wikipedia.org/wiki/International_Standard_Book_Number


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miller modigliani the fate of centrally planned econonomies

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