By: Frank Armstrong
By: Frank Armstrong, CFP, AIF
Back in my college finance classes, we struggled to construct an optimum corporate capital structure. Smart corporate finance officers supposedly minimized the cost of capital and/or maximized corporate value with an adroit mix of stocks, bonds, and bank borrowing. Given various cost of capital estimates, the appropriate stock/bond/borrowing equation would emerge after some mind-numbing math–remember, these were the days before spreadsheets. Presumably the astute CFO entertained himself daily with this exercise.
Much of my misspent youth also involved arcane analysis of dividend “signals.” In theory, careful examination of a company’s dividend policy revealed insider knowledge of the company’s prospects as viewed from the boardroom. A simple resolution to continue a long-standing dividend sent waves up and down Wall Street, and stocks with reliable dividends were highly prized by investors. An omission or reduction of a dividend foretold disaster.
How times have changed, thanks in large part to Merton H. Miller and Franco Modigliani. The duo published The Cost of Capital, Corporate Finance, and the Theory of Investment in 1958–and turned corporate finance upside down. In fact, Modigliani, today a professor at Massachusetts Institute of Technology, and Miller, a professor at the University of Chicago Graduate School of Business, both received Nobel Prizes in Economics in large part for their collaborative work.
Borrow Little, Borrow Lots–It’s All the Same
Miller and Modigliani argued that in an efficient capital market with no tax distortions, the relative proportion of debt and equity in a corporate capitalization does not affect the total market value of the firm. In other words, no matter how you slice the pie, the total value of the various parts remains constant. While leverage may affect the growth rate of the equity, it comes with a cost of risk. This change in leverage is identical to “homemade leverage,” where the shareholder simply margins the holdings. Thus the firm cannot do anything for shareholders that they couldn’t do for themselves.
If a firm’s value is unaffected by capital structure, management should spend its time developing real ways to improve shareholder value, rather than tinkering with the balance sheet. The central question isn’t how an activity should be financed, but whether it is worth doing at all.
To prove it, Miller and Modigliani developed a unique arbitrage argument. If fiddling with the balance sheet did, in fact, affect shareholder value, arbitragers would quickly move in, and by buying or selling the stock, they’d adjust the share price. In an efficient market, such value and price discrepancies could not exist. This type of proof is standard today, but unheard of back in the 1950s.
As a result of Miller and Modigliani’s findings, corporate governance has been revolutionized. Emphasis on creating real shareholder value emerged as a top priority for management. Subsequent corporate restructuring and refinancing focused on real profit opportunities, paving the way for the tremendous runup in stock we’ve seen during the past 20 years.
Dividends: No Be-All, End-All
Miller and Modigliani took an equally radical position on dividends. In a subsequent paper, “Dividend Policy, Growth, and Valuation of Shares,” they assert that a company’s value is unrelated to its dividend policy.
By paying out a dividend, a company reduces its capital–capital it could be using elsewhere. As far as Miller and Modigliani were concerned, dividend policy was irrelevant to stock analysis. Today’s investors seem to agree. Is anyone worried that Microsoft doesn’t pay dividends? Of course not, because Microsoft’s management has spent excess cash on reinvestment–profitable reinvestment–rather than paying it out to shareholders as dividends.