Modigliani and Miller's Economic Models - Essay Example

? JPMorgan Income and PLC. In what ways do the main Modigliani and Miller (MM) economic models of gearing fail Introduction During 1950s, Modigliani and Miller gained popularity for their intense study on the capital-structure theory. Their study led into the emergence of what popularly came to be referred to as the capital-structure irrelevance proposition. They both made prepositions about there being no significant difference as regards the type of capital structure a company employs when it finances its operations (Edwards, 1987). The professors further theorized about the market value a any given firm being determined by not only the earning power of the given firm, but also by the risk associated to he underlying assets of the firm with the firms value being independent of the way it chooses to finance its investment or the distribution of the dividends. The capital structure theorists who are perceived to be orthodox are mainly divided into two different groups with the fundamentalists like Modigliani and Miller making arguments bout the world approaching perfection very much closely with the imperfections which might be offsetting to a great extent which consequently makes gearing not to matter in the real sense. Amongst the scholars classified as the revisionists include finance text authors who are famous for writing for a wide group of audience for whom theoretical ingenuity may in real terms not imply to the highest value but instead make attempts towards accommodating, though, within the confines of orthodoxy in what is described as the stark difference between Modigliani and Millers both theoretical analysis and empirical observations as regards to the importance that has been based on a firms capital structure not only by the firm itself, but by also the investors (Findlay and Williams, 1985). It is therefore evident that what they are in real sense arguing about is the importance of imperfections which further which further attributes to the reason making gearing very important hence they play quite a critical role in making us understand why different firms make the gearing decisions the way they do. This study will therefore critically analyze both the fundamentalist and revisionist positions. The Modigliani and Miller argument is mainly founded on the following basic assumptions; That there is absence of taxes, the absence of the costs of transactions, that there are no costs of bankruptcy, that there exists equivalence in the costs of borrowing not only for the companies, but also the investors, that there exists symmetry in the flow of market information as regards to both the companies and investors being in know how with the given information (Edwards, 1987). Lastly, the theory is based on the assumption that there exists no significant effect as regards the effect of debt on the earnings of the company before interest and taxes (Findlay and Williams, 1985). It must however be noted that the reality existent in the real world is that there are taxes, costs of bankruptcy, the costs of transactions, existence of various differences in not only the costs of borrowing, but also the asymmetries in the flow of information and the effects debts has on earnings. Thus, to gain a better understanding of the failures of Modigliani and Miller (MM) economic models of gearing, we will first briefly look at both prepositions. Modigliani and Miller’s Capital-structure Irrelevance proposition The capital structure irrelevance proposition propagated by Modigliani and Miller makes assumptions of the lack of both taxes and the costs of bankruptcy. According to the proposition, they argue that the weighted cost of capital of any given company remains constant in disregard to the numerous changes in the structure of any firm’s capital structure. A good example would the rate of borrowing of a given firm which would result in no tax benefits resulting from payments of interest hence resulting to no changes or benefits as regards the companies weighted average cost of capital (Findlay and Williams, 1985). Consequently, the absence of any changes or benefits despite the increase in debt results to the capital structure not influencing the price of a given company’s stock which in the real sense implies that the company’s capital structure is irrelevant to its stock price. The biggest and most significant failure of this proposition is the assumptions of the lack of both taxes and the costs of bankruptcy. The real business world has to do with the costs of bankruptcy and the payment of taxes as they have significant effects on the stock price of any given company. Modigliani and Miller’s Tradeoff Theory of Leverage This theory makes assumptions as regards the benefits attributed to leverage within the context of a capital structure till optimal capital structure is achieved. Interesting to note, however, is that the theory takes into consideration the tax benefit from interest payments since tax is deducted on the paid interest on the debt hence the issuing of consequently makes the tax liability payable by the company less. It must however be noted that the making payments of dividends on equity does not (Findlay and Williams, 1985). Various studies of economics literature by renowned authors have however postulated that most companies have less leverage than that propagated for as optimal in the theory. Summary As regards the numerous facts of company finance, it is evident that the neoclassical theorists have attributed the differences to the various imperfections as well as various factors of secondary importance in addition to the incidental nature which impinge on the numerous financial choices that are contingently but not very essential to the fundamental logic of the operation of pure market forces. Thus, considering the neutral money view both in the original and the revisionist forms, we are justified to reject the notion that the various decisions which tend to determine the capital structures of a firm largely depend on numerous factors which are superficial in some sense as regards to the economy in which they operate (Findlay and Williams, 1985). The truth is that gearing plays a significant role not only because of the imperfections preventing the operations of pure market forces, but because of the essential features of the operations of the various companies (Findlay and Williams, 1985). It further provides other alternatives through which the understanding of the determination of gearing levels in terms of both two central and inescapable characteristics attributed to the various essential features of a company’s operations in addition to the intractable uncertainty of the environment and the position of fixity of the firm within it. The argued characteristics create conditions limiting the extent to which the given firm can raise its gearing level but through which the same given limits it can make the higher as compared to the lower gearing much more desirable. Any firm facing this situation makes attempts to resolving the conflict inherent in the situation not through searching for an optimal capital structure which has proved to lack meaning in the current world faced with uncertainty but instead through setting for itself a debt ratio that has a high likelihood of producing a workable compromise. Discuss some alternative explanations for the actual gearing levels of a company you know well The company that we will consider during this study is JPMorgan income and growth plc. which operates in the Equity Investment Instruments sector. The main investment objectives of the company are to meet its final capital entitlement of the income shareholders while at the same time providing them with regular and quarterly income in addition to providing them with capital growth for capital shareholders. The company, in a bid to manage risk has invested in a diversified portfolio which comprises of around 50 to 70 UK equities and a wide range of other assets. Despite the investments being primarily UK equities, the company has the flexibility that varies the allocation between UK equities in addition to other assets seeking the best absolute returns (Findlay and Williams, 1985). Gearing ratios are use for measuring the extent to which a company uses the assets financed by non owner supplied funds. With increase in the gearing ratio, the higher the ratio, the more the financial risk. The ratio measures the debt finance a company compared to its equity finance. The current capital gearing ratio of Jpmorgan income growth PLC is currently at 57.27% meaning that it is highly geared. While the excessive gearing would be related to risks associated with the firm which in real sense they would wish to avoid, the case of this company would be attributed to the need to maintain their position of economicfixity mostly dictated by the role of the company in production which has proved to endow them to the general kind of creditworthiness which they have successfully exploited. References Edwards, J, 1987, Recent Developments in the Theory of Corporate Finance Oxford Review of Economic Policy VOI.3, No.4 (Winter 1987), pp. 1-12 Findlay, M C and Williams, E E, 1985, A Post Keynesian View of Modern Financial Economics: In Search of Alternative Paradigms Journal of Business Finance and Accounting, Vol. 12, No. 1, (Spring 1985), pp.1-18 Findlay, M C and Williams, E E, Toward A Positive Theory of Corporate Financial Policy Abacus VO1.23, No.2 (1987) pp. 107-21 Kalecki, M, 1937, The Principle Of Increasing Risk Economics, VO1.4. Keynes, J M, 1936, The General Theory of Employment Interest and Money Macmillan. Murray, G, 1996, Modigliani-Miller On Capital Structure: A Post-Keynesian Critique, UEL Department of Economics Working Paper, No. 8 December 1996 Read More