Famous Academic Model.

Abused by Central Planners: Government Bridges to Nowhere

It has often been said that debt doesnt matter in the hallowed halls of Academia. When considering the finance alternatives to cash vs debt there are many theses which would suggest that, in a vacuum, capital structure doesnt matter which was popularized many years ago by an award winning team known as Miller Modigliani. By their own admission, this famous duo had no actual ideas about corporate finance despite being asked to teach the subject. They reviewed existing work on the subject, and formed their own theories which somehow made it to mainstream academia. We present for argument, one of the most widely used and famous theories in modern finance: The Miller Modigliani Hypothesis! Debt Doesnt Matter, nor does it affect Capital Structure In the Miller Modigliani framework, MM hypothesized that capital structure doesnt matter meaning that if one financed a business with 100% debt or 100% equity that the resulting business would be the same, since in a vacuum, the aggregate value of total investment would have also been the same. Of course we understand that this is ridiculous in hindsight. People do incredible stupid things when they spend other peoples money vs their own money. What about sustainability? Short Term Thinking We are far less interested in debating debt as good or evil as a method of funding a business, and more interested in the conversation regarding behavioral differences between debt financed companies and equity financed companies. Some would perhaps correctly argue that some debt is good as it keeps management on its toes, drives for more efficiency, etc.

whereas too much debt may lead to riskier behavior of managers trying to qualify or remain within covenants set by their creditors. What people can generally agree on is that a 100% debt financed business may have far less value than a 100% equity financed business. Why? Simple. A 100% debt financed business has the burden of debt, and zero ownership of the company by management in which case the incentive to drive the business is rationally impaired. The only carrot left for management is that without performance comes the loss of ones job, but theres no other known incentive. Zero Incentives for Success, Qualification for Stimulus instead of Viability of Franchise A 100% equity financed business perhaps must, by virtue of its zero debt structure, remain highly cautious, it will not give away equity to new people since owners are directly tied to the profitability of the firm, and investment decisions must be much more conservatively made, lest management throws valuable working capital into investments without proper focus on the return on those investments. Investment cycles and related return cycles would behaviorally trend longer vs shorter, and probably take more collective vote since everyones equity would be directly affected. Old Models without Modern Significance: Everything Living Dies when Left in a Vaccuum Modern-day finance and government spending and central planning among governments now looks much like a highly ingenious if not bastardized version of the famous Miller Modigliani financial framework. Comparisons are so uncannily similar that it must be seen to be believed. Modern day politicians in America would content that not only does debt not matter (capital structure doesnt matter) but also the idea that whomever spends that money, as a second derivative of MM (Miller Modigliani) also doesnt matter since under this apparently altered MM framework, who spends the money as a percentage of GDP no longer matters, either. In fact, if the general public spends the money and invests for growth, thats fine, but if the government spends the money instead, well then we are calling that equal under the revised and government imposed MM Framework. Example American of Chinese Business: Bob and John create a store which services cars. Change oil, new tires, etc. People hired, jobs created, and if successful through service to others, Bob and John will open many more stores and serve more people. Bob and John become wealthy and will, as a service to others, likely teach others how to do similar business with direct, on the ground knowledge of customers and trends. Without continuing to listen carefully, the business is always in danger of failure. Bob and John pay a third of their net profits to the government. Example Bureaucratic Business, Government Planned:

Bob and John are hired to run a store which services cars. The store makes money or doesnt make money; Bob and John keep opening more stores. More people are served, bureaucrats stop in to see if the stores are kept clean. Government continues to open more stores and while profitability isnt mandatory, if the business loses cash, it is all to serve the people so its dismissed as important. The government collects no taxes regardless. There is no incentive to innovate. One model is financed with the blood, sweat and tears of its founders who must maintain an immigrant mindset which is incredibly frugal and responsive to customers, and must remain highly adaptive to markets lest founders lose what they have created. The borrowed model with 100% borrowed money (borrowed from taxpayers) is a model without incentive to listen, without incentive to remain competitive, and without profitability (efficiency) ad a demand before embarking on expansion. The sociology of these two models is without argument, and yet with government growing in America from 25% of GDP to its current 35% of GDP we must wonder. Are the Washington political elite using a 40 year old model of Miller Modigliani to drive their decision-making despite all evidence that this model only works in a vacuum? The Sociology of Debt: As outside debt investment or borrowing is used to substitute human capital, we begin to throw the sustainability argument out the window, no better explained as the USA borrows more and more money to finance GDP which cannot grow on its own.

Our model is a model of human history. That model is thousands of years old. That model states unequivocally that ownership matters and when using borrowed money to finance ones dreams, equity is impaired. When borrowing 100% of the money for ones dreams, people lack skin in the game to persist in tough times, leading to mass business failures based on this same faulty logic. Its much worse than that though..for when an entire country borrows money to create businesses for which there is no demand, and expects these people to maintain proper incentive to maintain a franchise.then we are not just one or two but three steps removed from a reality in which a business would then feel compelled to serve the people. This process in America is called Stimulus Spending and the process, just like Miller Modigliani, only works in a vacuum. As in any vacuum, without the oxygen which we will define as demand by the people we opine that the business generated within this vacuum is unsustainable; and without this oxygen, business lacks sustainability and must necessarily fail.

References:

Brealey, Richard A.; Myers, Stewart C. (2008) [1981]. Principles of Corporate Finance (9th ed.). Boston: McGraw-Hill/Irwin. ISBN 978-0-07-340510-0. Stewart, G. Bennett (1991). The Quest for Value: The EVA management guide. New York: HarperBusiness. ISBN 0-88730-418-4. Modigliani, F.; Miller, M. (1958). "The Cost of Capital, Corporation Finance and the Theory of Investment". American Economic Review 48 (3): 261297. Modigliani, F.; Miller, M. (1963). "Corporate income taxes and the cost of capital: a correction". American Economic Review 53 (3): 433443. Miles, J.; Ezzell, J. (1980). "The weighted average cost of capital, perfect capital markets and project life: a clarification". Journal of Financial and Quantitative Analysis 15: 719730. doi:10.2307/2330405.
Ruben D Cohen: An Implication of the Modigliani-Miller Capital Structuring Theorems on the Relation between Equity and Debt