TCS Daily

Slicing the Pizza in Perfect Capital Markets

By Arnold Kling - August 1, 2005 12:00 AM

Editors note: this is the third in a series of essays on financial markets and the economy.

"People often ask: Can you summarize your theory quickly? Well, I say, you understand the M&M theorem, if you know why this is a joke: The pizza delivery man comes to Yogi Berra after the game and says, Yogi, how do you want this pizza cut, into quarters or eighths? And Yogi says, cut it in eight pieces. I'm feeling hungry tonight.


Everyone recognizes that's a joke because obviously the number and shape of the pieces doesn't affect the size of the pizza. And similarly, the stocks, bonds, warrants, etc., issued don't affect the aggregate value of the firm. They just slice up the underlying earnings in different ways.


...Reporters would say, you mean they gave you guys a Nobel Prize for something as obvious as that? [Lots of laughter.] And I'd add, Yes, but remember, we proved it rigorously."
-- Merton Miller


In 1958, Merton Miller and Franco Modigliani startled the world of financial economics by suggesting that the firm's capital decision -- whether to finance its investment using debt or equity -- should not matter. Their demonstration, known today as MM, was one of those elegant scientific results that is completely counterintuitive beforehand and blindingly obvious afterward.


Since MM was published, economists have realized that:


  • Risk is neither created nor destroyed in financial markets. Instead, risk depends on the nature of the investment projects that are undertaken.
  • The capital structure decision of the firm cannot be analyzed in isolation. It takes place in the context of portfolio decisions by individuals which can offset or "undo" the risk characteristics of the firm's decision.
  • The ability of individuals to re-allocate portfolios to take advantage of pricing anomalies creates opportunities for tax and regulatory arbitrage. Attempts by the government to regulate or manipulate capital markets will often generate profit opportunities without changing the underlying investment patterns.


The Irrelevance of Capital Structure


Imagine that it's 1998 and you are running a telecom company. That year's Kool-Aid, rich and full-bodied, gives a warm tingle as it glides down your throat. After swallowing, you decide to invest $10 billion in order to build enough infrastructure over the next three years to produce a 1000-fold increase in your capacity to carry data. Assuming that the Internet is increasing the demand for bandwidth at the rate of 10X per year, this will just allow you to meet the need in 2001. You could sell shares of stock to raise the $10 billion, but you choose to issue $10 billion of debt instead.


As it turns out, bandwidth demand increases at a rate of 3X per year, which is very rapid, but well short of your expectations. It means that by 2001 your capacity requirements have gone up by only a factor of 27, not a factor of 1000. It turns out that you over-invested, and the new capacity in which you invested $10 billion is now worth about $0.3 billion. After you have finished paying off your debt obligations, your shareholders are out $9.7 billion.


Where did you go wrong? Conventional "folk finance" would put some of the blame on your financial leverage, meaning the decision to raise funds by issuing debt instead of selling stock. However, the MM theorem says that the issue of how you financed the investment is essentially irrelevant. Your decision to spend $10 billion on capacity that turned out to be worth $0.3 billion loses your shareholders $9.7 billion regardless of how it is financed.


Before MM, the conventional wisdom was that highly-levered firms (firms that issue a lot of debt relative to equity) offered their investors higher risks and higher expected returns than less-levered firms. MM said that financial structure was essentially irrelevant.  


Let us return to our Food Court economy, in which investment projects consist of developing and testing new recipes. A low-risk project might be an attempt to find a recipe for sesame noodles that tastes good without using peanuts. A high-risk project might be an attempt to grow meat in a lab, which would reduce the need to kill animals for meat.


What MM says is that you cannot turn the sesame noodle project into a high-risk, high-return investment by funding it with debt. Conversely, you cannot turn the cultured meat project into a low-risk, low-return project by funding it with equity. Investors must bear the underlying risk of the project, regardless of how it is financed.


Arbitrage and Personal Portfolios


One of the ways that MM represents the first paper in modern finance is that it uses an arbitrage argument. That is, it looks not just at how the firm decides to issue securities, but also at how investors might choose to trade and re-combine those securities.


For example, suppose that an investor wants to hold a portfolio that will earn a very high return if the sesame noodle recipe project is successful. Unfortunately for our investor, the company is financed "conservatively," without issuing any debt. The MM argument is that the individual investor can borrow money to acquire stock in the sesame noodle project, thus creating for himself a highly levered position in the noodle recipe. Buying a low-risk stock on margin accomplishes the same thing as buying a high-risk stock without engaging in borrowing.


The MM argument is that personal leverage and corporate leverage are substitutes. Regardless of how the firm finances its projects, the individual investor can either purchase or issue debt securities in order to adjust up or down his degree of exposure to suit his preferences. Someone who invests in the sesame noodle project can create a risky portfolio by borrowing to finance his investment. By the same token, someone who likes the cultured meat project but has low risk tolerance can put 99 percent of his money in risk-free bonds and 1 percent in stock in the company attempting to develop cultured meat. Overall, the investor has a low-risk portfolio, even though his stock is a risky one.


Suppose that two firms invest in identical projects, and one issues a lot of debt while the other finances its project mostly using equity. If the market values the low-debt firm at $110 million and the high-debt firm at $100 million, then an arbitrageur can short the shares of the low-debt firm, buy shares in the high-debt firm, and invest in debt to offset the extra leverage that the high-debt firm represents. The result will be a guaranteed profit. As arbitrageurs take advantage of this opportunity, the difference in market value between the two firms will disappear.


The arbitrage argument says that the investor "sees through" the financial structure of the firm and looks directly at the risk of the underlying projects. It also says that whatever position the firm takes with its financial leverage decision, the individual can offset or "undo" the firm's decision by altering the composition of the individual's own portfolio.


Tax Arbitrage and Regulatory Arbitrage


One of the implications of MM is that tax arbitrage seems easy and important. Corporate finance becomes a game of trying to extract the most possible advantages from the tax system.


For example, suppose that interest on debt can be deducted as an expense from corporate income, but that there are classes of investors for whom interest income is not taxable (pension funds and individual retirement accounts, for example). In that case, by issuing debt, and having the debt purchased by tax-privileged investors, the firm can take advantage of tax arbitrage.


If tax arbitrage were everything, then pensions might hold bonds as assets, in order to take advantage of their high yields. But then there is regulatory arbitrage to consider. The Pension Benefits Guarantee Corporation (PBGC), the U.S. agency which guarantees private pensions, charges the same fee to corporate pension funds regardless of risk. From a corporation's point of view, the way to take advantage of this is to maintain the riskiest possible pension fund. If things go well, take profits out of the fund and give them to shareholders. If things go poorly, then let the government bail out the pension fund.


As financial markets get more efficient, tax and regulatory arbitrage becomes an increasingly powerful motivating factor in financial decisions. Government policy has less and less effect on the underlying economic risks, and at the same time it creates more and more opportunities for risk-free profits to be earned at taxpayer expense.


Risk is in the Recipes


The Modigliani-Miller theorem completely changes the way we think about financial markets and risk. Prior to MM, folk finance thought of risk in terms of individual transactions. It was thought that choosing a capital structure with more debt and less equity increased risk.


After MM, economists no longer could accept the notion of looking at risk transaction by transaction. Instead, we try to anticipate what will happen after individuals have adjusted their portfolios in reaction to any particular transaction. That in turn leads to a focus on the true underlying risks in the economy.


In terms of our Food Court metaphor, the real risk in the economy is in the process of searching for new recipes, not in the way that firms finance that search. In a chemical reaction, old compounds are transformed into new compounds, but matter is neither created nor destroyed. Similarly, in a financial restructuring, one set of cash flows may be re-arranged into a new set of cash flows, but risk and return are neither created nor destroyed.


At this point, we are focused on the riskiness of the projects that search for new recipes. One might think that we are ready to say that the greater the variation in the possible results of the project, the more risky it will be viewed by the market. But we have another surprise in store, which will come out in the next essay.


Arnold Kling is the author of Learning Economics



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