CF 12-1A – M&M Proposition I and Homemade Leverage – Corporate Finance

Well, let's have a look at problem 12, one, a all about leverage, all about M and M Modigliani and Miller, some Nobel prize winners, and they won their Nobel prize for this concept. And it's a little weird, actually, that they won their Nobel prize for this concept, because as we'll discuss at the end, there's lots of problems with this proposition, but let's jump into the problem. We'll solve the problem. Then we'll just discuss M and M a little bit more at the end, XYZ company has no debt and is financed 100% through equity. Sorry, I'm just clicking on something here. The company has 800 common shares outstanding and the price per share is $150 and it is expected to be $10,000 per year. Okay, you invested in this company because you love their debt free capital structure. You're a fan of Dave Ramsey, Google Dave Ramsey, if you don't know who that is, that's a person who hates debt. You've invested in a company because you like them because they don't have any debt either. You own 120 common shares, so that's what you bought. Assuming a dividend payout rate of 100% and assuming no taxes, that's a big assumption, that's one of the big problems or challenges to this M and M proposition, what's your cash flow from owning the shares? Okay, so they're going to pay 100% of their profits and it said their EBIT is $10,000 per year and then that's earnings before interest and taxes. So their interest, if they have no debt, is zero. Their taxes, if we assume away taxes, one of the big critiques of this method is zero. So their profits are $10,000 and they're going to pay it all out. So the question is how much of the company do I own? I own 120 shares, there are 800 shares out there. I own 120, eight hundredths of the company, 120, I don't know why I said eight hundredths like that. I own 120 of 800 shares, I own 15% of the company. So I'm entitled to 15% of that when they dividend it out. So 15% of $10,000 means this thing's going to be giving me $1,500 per year in perpetuity. So that's my ongoing cashflow from owning the shares. That's the answer to question one. Okay, question two. The company is debating between, debating borrowing money in a way that would make its capital structure 25% debt and 75% equity. We don't like that because we invest in this because we love that they're debt free. Maybe we still love the company, but we're not happy with this. The interest on the debt, we only own 15% though, so we can't tell them what to do. The interest on the debt would be 6%. After borrowing, the total assets of the company would remain the same. The money would be used to buy back shares. You intend to keep all 120 of your shares. What would the cashflow be under this new capital structure? Okay, let's compare the capital structure. I'll do one in maybe blue. So this is actually, let's do it in red. The old one, old structure, and then we'll have a proposed structure over here in green, just to kind of lay out what the balance sheets are going to look like before and after. I think it'll be very helpful in understanding what on earth is going on here. So we know balance sheet looks like this. Assets equals liabilities plus shareholders' equity. So let's think about it for the first version of the company. Company had 800 shares. Shares were 150 bucks a share. So 800 times 150 bucks a share means $120,000 of equity. It had zero debt. So what are the assets? Well, zero plus 120 is 120. The assets must be 120 or this balance sheet doesn't balance and accounting doesn't work and my whole life was a fraud. So I think it works. I think that makes our balance sheet balance. Let's look at the proposed structure, our assets, liabilities, shareholders' equity. In the proposed structure, it says the company is debating borrowing money that would give a capital structure of 25% debt, 75% equity. The interest is going to be 6%. After borrowing the total assets, the company would remain the same. Okay, so our total assets are still going to be 120. We're just going to take on some debt and get rid of some equity. So it said 75% of this is going to be equity. So 120 times 0.75 is 90,000 is going to be equity and 30,000, then I'm just doing the math, 90 plus 30 is 120 and 30,000 is 25% of 120. So that's what it's going to look like afterwards. Now we keep all 120 shares. How many shares have to get canceled here? Our shareholders' equity goes down by $30,000. How many shares is that $30,000 reduction in equity? So we said that the shares are $150 each and we reduced our equity by $30,000. How many shares did we cancel? Looks like 200, but let's run the numbers here. 30,000 divided by 150. Yeah, we must have canceled 200 shares, canceled, bought back 200 shares. So company buys back 200 shares, leaving it, it had 800. Well, now it's got, it got bought back 200. So now there's 600 shares out there in the world and we still own 120 of them. We own 120 now out of 600 shares, not 120 out of 800. We own 120, 600 of the company, 120 divided by 600. I don't know why it sounded funny to me. Maybe just me. We own 20% of this company. Okay. So there's newly, you know, restructured company. Now we own a bigger chunk of, we own 20%. Let's look at its income statement from EBITDA. So I bet it's going to be $10,000. It's expected to be $10,000. Our interest, now we do have interest. We borrowed 30 grand, 6% annual interest, 30 times 6%, $1,800 in interest. Our taxes, we're still assuming are assumed a way to be zero. So our company's new net income is $8,200, 10,000 minus 1,800. We own 20% of it. So 8,200 times 0.2, we own 1,640. So what would your cashflow be under the new capital structure? Our piece of the pie is 1,640. Now this will happen when a company takes on more debt. It generally will always look better for the shareholder in this type of proposal. And as we saw last chapter with weighted average cost of capital, debt capital is cheaper. So often you're encouraged here to take on more and more debt. But there may be reasons we don't want to. Maybe we don't want to take on the risk in our portfolio, right? We have a portfolio of companies and this was meant to be our lowest risk play. And now they're taking on debt. We don't like it. Or we could be like Dave Ramsey, that guy I was telling you about. He's a YouTube celebrity. He's a famous personal finance person. He just hates debt. He's allergic to it. So you would hate to invest in a company that takes on a bunch of new debt. So maybe he's opposed to it in that sense or whatever. We're just opposed to taking on new debt. So here's what Miller and Modigliani say. They say, whatever the company does, it doesn't matter if they take on debt or not. If they have lots of debt or they have lots of equity, because you as a shareholder can just move your portfolio around and adjust around. So for instance, if you're invested in a company and you wanted them to take on more debt and they had no debt, well, what you could do is borrow money yourself and buy more shares and you're leveraging yourself up. Or if is the case here, they borrowed money and you don't want them to, you can take money out of that investment and invest in something safer. Or even as we're going to propose here, become a lender. Like you just take the other side of the bet. They're borrowing a bunch of money. You don't want it. Well, you lend a bunch of money to somebody safe with a similar profile to this company. If the company borrows as proposed in part B above, how could you make use of homemade leverage so you just make your own leverage to adjust for this? Well, the way you would do it is you would say, okay, they've taken on 25% debt. We don't like that piece of the investment. We're going to sell 25% of our shares to adjust for that, right? That piece of our investment we're unhappy with, and we're going to maneuver that piece and just take the opposite bet with that piece of the pot. So we had 120 shares. We're going to sell 25% of them at, so 120 times 25%. I think it's 30. Should do this in different color ink. Well, I think that's wrong. 120 times 0.25. It's got to be 30. Yeah, 30. I don't know how I got 31.25 there. Let me do this in blue ink. So it's 30 shares to sell at $150 each. That's $4,500 in cash, and the idea is we should become a lender with that, and it counteracts the other side, right? It counteracts what the company has done because we are on the other side of the bet with that piece of the portfolio. So 4,500, and let's just say we can get 6%, same rate here. We're just in the exact equal and opposite position, and it just cancels out. We end up in the exact same place we were. That's the idea here. 4,500 times 6%. It's $270 coming in as far as interest revenue on that loan goes. So there's our interest rev on the loan. Now, what's the other piece? Well, this company is still the same. They still have net income of $8,200. If we sell 30 shares, how much of the company do we own? We own 90 shares. Now, we owned 120. I'm all over the page here. We owned 120 out of 600. Now, we own 90 out of 600. So we own what percent of the company? 90 divided by 600. We own 15% of the company again. So we own 15% of this $8,200 profit. I think it's probably behind my head. Let's do the math. 8,200 profit times 15% is 1,230 in dividend income. We have 270 in interest revenue. We have 1,230 in dividend income. We are $1,500 in revenue from our investment. And because we're on opposite sides of the same bet, we're in the exact same place as far as risk goes. We've laid off that risk. We've passed along the risk, I guess. Counteracted, it might be the best way of saying it. So we've solved 12-1A. A quick comment on this M&M proposition. It's a very interesting insight and a useful insight. And it's worthy of its Nobel Prize win. So if I sound like I'm criticizing it, I'm really not. You need to use it as a thought exercise. So the idea is, I think, a really smart insight. And that is, if you're invested in a company and it's not taking on enough risk, you just take on more risk yourself. Let the company do what it's going to do. And as an investor, you're rational to just take on more risk yourself in your own portfolio. If they're not risky enough, well, it's on you to, if they're too risky, rather, it's on you to reduce the risk. And again, make portfolio adjustments to reduce the risk. They sort of say, therefore, because we assume investors are rational and markets are efficient, that's what'll happen. And therefore, it doesn't matter what the company's capital structure is. In reality, a big factor here is income tax, which people are taxed differently than companies. And debt is tax deductible in the hands of a company, not in the hands of an individual, the interest on debt, I should say. Bankruptcy is a thing that is just really not contemplated in their proposition. And finally, markets aren't always efficient and people don't always behave ethically and rationally. So a lot of things cause this to fall apart. On a fundamental level, though, it's like you have to assume no taxes for it to work this way. I think as a thought exercise, very insightful though, very insightful. You as an investor are rational to shape your portfolio around the company and you can certainly do that. And I think that's a reasonable insight. And I think, obviously, a Nobel Prize-worthy insight the way it's laid out. And I don't think I've done it justice here. But in reality, it sort of falls apart when faced with real world, what's the word here? Constraints, I suppose. It assumes away many real world constraints that are all too legitimate. Anyway, I've rambled long enough. Thanks for watching and I'll see you in our next video. Goodbye.