Financial Discussion Thread on Modigliani–Miller, and the actual relevance/logic/value of the theory

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Discussion Thread on Modigliani–Miller, and the actual relevance/logic/value of the theory Posted: 22 Nov 2018 03:10 PM PST I wanted to put up a discussion thread to talk to people on this theory. I'd come across it in my undergrad years and just recently re-visited the theory. Here's a Wikipedia link. The basic idea is this: "In the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed". And this: "Consider two firms which are identical except for their financial structures. The first (Firm U) is unlevered: that is, it is financed by equity only. The other (Firm L) is levered: it is financed partly by equity, and partly by debt. The Modigliani–Miller theorem states that the value of the two firms is the same." I work in Structured Credit where Asset-Backed Securities are issued, and my gut reaction is that if this theory were true - even including all the assumptions stated - a great deal of securitized products would not be issued. For background, there are broadly two reasons a securitization would be issued: If the issuer wants to get attractive non-recourse leverage on a pool of their assets (ie they retain the equity) or if they want to sell a portfolio of assets completely, and believe that the sum of proceeds from the debt and equity they sell would be greater than the proceeds from selling an unlevered asset pool (ie they sell the equity to a third party). This second reason flies in the face of Modigliani Miller. But issuers sell third-party equity all the time. It seems to me that what MM doesn't address is that debt investors and equity investors are disparate market segments, each with their own supply/demand dynamics. If there's a glut of capital chasing BBB opportunities they would push down the yields on BBB bonds. The same for AAA and the same for 10%+ yielding equity residuals. Given that there are all different market segments, it seems completely possible that the WACC of a company's funding structure would not be the same as the ROA. And, as far as I'm aware, all of that can happen in a market that is still efficient. I understand that economic theories are usually highly abstracted, and often so general (or involving so many assumptions) that they don't directly point to the truth in economics, but only address partial truths. So I wanted to put it up to a discussion. What do you think are the merits of the theory? submitted by /u/Matrigan [link] [comments]

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