FROM MODIGLIANI-MILLER TO MODERN

CORPORATE FINANCE
Prof. Dr. Wolf Wagner
RSM

Lecture 1, Corporate Finance (BM02FI)

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Part I
Explanation of the course

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Today

Introduction: Course content and objectives

Course structure
First lecture: Basic considerations in capital structure

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Explanation of the course

Learn about corporate finance, in particular capital structure

Learn how to read scientific papers
Learn how to make good use of theories

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Explanation of the course

I deliver this course together with my colleague Dr. Yigitcan

Karabulut. I will do the first four lectures, after which Dr. Karabulut
takes over.
There are 8 plenary lectures, explaining the bigger picture, models
and empirical approaches, with references to the papers you are
required to read.
In these lectures, we will NOT literally follow these papers. The
lectures introduce you to the relevant papers to ease the reading.
However you have to read the papers yourself!

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Readings for this course

This course is based on papers (no textbook)

The course requires a lot of reading (approx. 800 pages of academic
papers).
All papers are mentioned in the course manual (available on
Blackboard), and can be downloaded for free.
For those who wish to refresh their prior knowledge about a theme,
the course manual suggests background readings for each lecture
based on chapters of some popular basic textbooks (Ross,
Westerfield, Jae and Jordan; Brealey and Myers; and Berk and
DeMarzo). These readings are NOT part of this course, and only
meant as support in case you are lost.

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Course assessment

The final written exam (85% of your maximum final grade) will
consist of open-ended questions.
A question typically deals with one particular paper so we try to
cover about one paper of each lecture in an exam question.
In these questions, we often give away the conclusions of some
particular paper, and ask you to explain how the author(s) have come
to that conclusion.
Hence, you really need to understand what the papers are all about
(do not memorize the papers).
We will upload a sample exam on Blackboard. I suggest you to have
a look at the sample exam to get a feel for what is expected from you
in the exam.

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Course assessment

This is a challenging course!

Please do not postpone the reading until the end of the course,
because you are likely to fail.
Read all suggested papers for a particular session before you come to
the lecture. This will greatly enhance your understanding of the
readings.

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Course assessment
We want to maximise the number of people passing this course. Our
past experience shows that if people fail this course, they
predominantly do so because they underestimated the workload
and thus started too late.
We therefore provide a number of compulsory assignments, in which
you are asked to reflect on a particular paper.
These assignments are set up in a similar spirit as your final exam
questions, so the idea is that by pushing you to work with the papers,
you increase your chances to pass.
You will have to upload your assignments electronically through our
BlackBoard page for this course.
I will hand out 3 assignments (at the end of lectures 1, 3, and 4). My
colleague Dr. Yigitcan Karabulut hands out his assignments at the
end of lecture 5, 6, and 7.
The first assignment is already uploaded and is due by Tuesday
September 6th noon (12.00hrs).
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Assignments

Each assignment is either rewarded with 0 pt or 0.3 pts. The

maximum of all assignments adds up to 1.5 pts, meaning you may
skip or lose out on one.
In order to keep the weekly grading manageable, we will randomly
divide students into three cohorts. You do not know in which cohort
you are. Every week, every handed in assignment receives full credits
by default. However, we will check one third of all assignments
(namely that weeks cohort). If your checked assignment appears to
be poor (and receives a fail) we will automatically check all three
assignments for that particular part of the course.

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Example: You hand in three poor assignments, but your cohort is only
checked in the third assignment. After two weeks you have received
the full credits for your assignments 1 and 2. Your third assignment,
however, is checked and gets a fail. We now check the quality of
assignments 1 and 2 as well, and the full credits you received earlier
are now corrected and reset to zero. ! Your assignment credits are
not final until the end of the course.

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Assignments
Everybody is checked at least once for each part of the course.
Therefore we will put everybody in a cohort at the end of each part of
the course (i.e., I will do this after assignment 3; my colleague
Karabulut after assignment 6). ! We make sure that if you have
handed in anything, you will be checked at least once per part of the
course.
Obviously, you want to learn your definite assignment result before
you come to the exam.
Therefore, it is good to know that I will do all my grading after
assignment 3 (so you know the definite grades for assignments 1/2/3
in between lecture 4 and 5). My colleague Karabulut will do all his
grading immediately after assignment 6 (due date before lecture 8),
and strives for finishing everything by the last Friday before the exam.

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Communication

When you have a question about the course materials, either:

Ask in class (in particular when of interest for the entire group);
Ask during the break or after the lecture
Ask at the discussion boards on BlackBoard:
Board on Lectures 1-4: Checked and answered by me, about once per
week.
Board on Lectures 5-8: Checked and answered by my colleague
Yigitcan Karabulut, about once per week.
NOTE that we may not be available for comments in the last days prior
to the exam.

Ask me during my oce hours for this course (Wednesdays

11:00-12:00 hrs.; only during my part of the course).

In the interest of ecient communication, minimize email contact

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Course and Exam Enrollment

Important message from MSc Programme Management:

If you are registered correctly for this course/programme you will have
Blackboard access to this course.
! Please check if you have BlackBoard access.
! If so: great, your registration was successful!
If you do NOT have Blackboard access for this course, this could
indicate that there is something wrong with your registration.
! If so: Please send an e-mail a.s.a.p. to msc.fi@rsm.nl, listing your
student number.

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Final remark

Even though this is a very large class, we strive to make this lecture
as interactive as possible
Please ask questions if you do not understand something. It is likely
that other students have a similar question.
Interactive lectures are also more enjoyable for teachers!
This is about the intro to the course.
For all the details, please check out Blackboard and the course
manual.
Lets get started...

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Part II
Modigliani-Miller and beyond

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From Modigliani-Miller to modern corporate finance

This topic is based on the following four papers:

Modigliani and Miller (AER, 1958)
Fama and French (JF, 1998)
Graham (JF, 2000)
Korteweg (JF, 2010)

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Learning objectives

Having studied the materials suggested, you should be able to understand

and explain:
The Modigliani-Miller propositions.
How a firms value is related to leverage (and dividends) in practice.
How theories of capital structure based on agency costs, asymmetric
information, market interaction, and corporate control, are related.
How financial leverage is related to flexibility with respect to
production and investment decisions.

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Part III
Modigliani & Miller (1958)

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Discussion of Modigliani & Miller (1958)

Back in 1958, Franco Modigliani and Merton Miller showed capital
structure was irrelevant to a firms cost of capital, and hence to
investment decisions.
The paper is not an easy read.You have to familiarise yourself with
their notation. E.g. you are probably used to re for denoting the cost
of equity, whereas M&M use ij to denote the cost of equity for
individual j.
It may help you to make a list of variables and equations needed to
build up the arguments, and then link them with notations you are
used to.
The ugly-looking ij = rk + (rk r )Dj /Sj (p.271) could become
re = r0 + (r0 rd ) DE .

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Modigliani & Miller (1958): Main assumptions

No taxes.
No transaction costs (particularly no cost associated with issuing new
debt or equity).
Neither direct nor indirect costs associated with bankruptcy.As a
consequence:
Individuals and corporations borrow at the same rate

No agency costs (managers act in the interest of shareholders,

shareholders aim at maximising firm value rather than expropriating
wealth from the firm at the expense from other stakeholders such as
creditors).

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Bankruptcy costs: An example

At t=0 a firm invest 100 in a project and raises 50 of debt (ignore

interest).
At t=1 the project only returns 30 and these returns (30) are
distributed among debtors.
What is the cost of bankruptcy?

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Modigliani & Miller (1958): Propositions

Proposition
MM Proposition I (no taxes): The value of the levered firm is the same as
the value of the unlevered firm (p.268)

Proposition
MM Proposition II: The return equity holders require increases with
leverage (p.271)

Proposition
MM Proposition IV (in the paper Proposition 3): In a perfect capital
market, given the investment decision of a firm, and given that the return
on the investment project exceeds the rwacc , the financial policy of a firm
is of no consequence.
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Discussion of Modigliani & Miller (1958)

In addition to propositions I, II, and IV, M&M also proposed:

Proposition
MM Proposition III: In a perfect capital market, whilst keeping the
investment policy of a firm fixed, the firms choice of dividend policy is
irrelevant and does not aect the initial share price.

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M&M Proposition I

Under their assumptions, Miller and Modigliani showed back in 1958

that debt adds no value to a company: Vlevered firm = Vunlevered firm .
There exist two proofs for that proposition:
1

Based on equivalence of pay-os of two firms with dierent capital

structure
Based on home-made leverage.

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M&M Proposition I: Theoretical explanation

In the absence of taxes (etc.) debt does not aect the underlying
cash flows of the firm (cash-flows of the entire enterprise not only to
equity)
Consider two identical firms, both deriving cash flows p from their
operations. Firm A is an all-equity firm, whereas firm B has a blend
of both debt and equity.
The interest rate on debt is rd .
Assume you are an investor, and buy fraction a of the total value
(being equity only) in firm A, and a same fraction a in the total value
(being a blend of debt and equity) in firm B.
Let us see what payo you receive after one period.

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M&M Proposition I: Theoretical explanation

Your income from either firm would be as follows.

Value of the firm
Firms cash flows
Your investment at t = 0
Your income at t = 1

Firm A
V firm = Vu
=E
p
aVu = aE
ap

Firm B
V firm = Vl
= D +E
p
aVl = aEl + aDl
a(re El ) + ard Dl
= a(p rd Dl ) + ard Dl
= ap

Since your income in firms A and B is equal, the price you will pay for
either firm must be the same as well
If, however, the values of the two firms are equal, then leverage does not
aect the value of the firm.

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MM Proposition I:

When taxes are introduced, debt does add value, simply because:
firm
firm
VLevered
= VUnlevered
+ Tc D.
As interest payments on debt are tax-deductible, we call the last term
the tax shield on debt.

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MM Proposition II:

Miller and Modigliani postulated in their MM Proposition II that

since equityholders are exposed to more risk when leverage increases,
the cost of the firms equity should rise as well (as more risk
translates into more return).
In their Proposition II, Miller and Modigliani derived the following
explicit relationship between leverage and the equity cost of capital:
re = r0 +

D
(r0 rd )
E

(1)

where r0 is the firms overall cost of capital (equalling the cost of

capital of unlevered equity).

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Application: debt-financed repurchases

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Since the financial crisis, corporations have been buying back shares
by vast amounts, financed mostly through debt

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M&M Proposition III (Dividend irrelevance)

A firms total market value is independent of its dividend policy. Why?

If we fix the firms investment policy, then a change in dividend policy
has to be met with a change in financing policy.
We know that financing policy has no eect on firm value, therefore
neither does a change in dividend policy
E.g., suppose firm pays out dividend. This can be met with an equity
issuance or a higher level of debt. However, the physical assets of the
firm are unchanged. The old investors plus the firms new investors
form a closed system; they hold the value of the firm between them.
Only change in capital structure

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MM: Dividend irrelevanceProof (1)

Let the value of a firm at time t be
Vt =

1
(Vt +1 + divt )
1 + rwacc

(2)

Suppose now the firm increases its dividends at date 0. Denote these
additional dividends as At .
Since the firm does not have the money to pay out these additional
dividends At , it issues new debt Dt to finance them.
The value of the firm then becomes:
Vt =

Wolf Wagner (RSM)

1
(Vt +1 + divt + At Dt )
1 + rwacc

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MM: Dividend irrelevanceProof (2)

Since the value of the newly issued debt Dt equals the value of the
additional dividends At , the value of the firm may be rewritten as:
Vt

=
=

1
(Vt +1 + divt + At At )
1 + rwacc
1
(Vt +1 + divt )
1 + rwacc

Hence, the value of the firm remains unchanged.

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M&M Proposition IV (Investment and capital structure)

Divide the decisions a firm can take into four parts:

1
2
3
4

How should the firm finance its investment?

How should the firm redistribute its earnings?
How much should the firm invest?
Which projects should the firm undertake?

Decisions (1) and (2) are the financial decisions, whereas decisions
(3) and (4) are the real or productive decisions.
Exercise: what does MM have to say about these decisions and how
they are related?

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Context for the next few lectures

MM is a useful benchmark but the real world is more complex =>

imperfections (relaxing assumption of MM)
Three theories:
Tradeo theory, focussing on the tax shield of debt;
Pecking order theory, focussing on information asymmetries between
insiders (managers) and outside financiers;
Free cash flow theory, focussing on agency costs.

These theories will be discussed in the first four lectures of this course.
Five decades after Modigliani & Miller, we do not have (and are not
likely to get) a universal theory that explains and predicts the
debt/equity choice for a modern corporation.

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Context for todays lecture

Today we predominantly focus on the tradeo theory of debt.

In the tradeo theory the optimal capital structure trades o:
Tax savings from debt financing, against
Cost of financial distress (incl. agency costs of issuing risky debt,
deadweight costs of liquidation or reorganisation, costs of debt
overhang, see Myers (1997)).

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Overview of next three papers

The Fama & French (1998) paper seeks to empirically test M&M
props 1, 2 & 4, but fails to find evidence. Even though Fama &
French have published more papers on this theme recently (e.g., in
2005), I wanted to discuss this classical paper.
The Graham (2000) paper puts the tradeo theory papers in context
by investigating how large the tax benefit of corporate debt really is.
The Korteweg (2010) paper gives a very elegant introduction into a
more recent development of the field, namely dynamic capital
structure.
Tax shield

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Some stylised facts on financial policies

Low leverage puzzle:
Many firms have almost no debt financing at all.
Firms seems to use external debt financing too conservatively, relative
to what the tradeo models would predict

Leverage appears to be heavily path-dependent, and persistent. See,

e.g., Strebulaev (2007, JF), Welch (2004, JPE), Baker & Wurgler
(2002, JF).
Leverage patterns seem similar across both developed and developing
countries.
According to Graham & Harvey (2001, JFE) who surveyed 392 CFOs,
the tax advantage was the fifth most important reason for issuing
debt (flexibility was mentioned to be the most important motivation
by the way).

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Part IV
Fama and French (1998)

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Fama and French (1998): Methodology

In 1963, Modigliani and Miller show that in the absence of taxes:

Vl = Vu + TC xD.
Fama and French empirically test that equation by regressing firm
value on interest expenses
They use the following proxies:
Interest rate expense: proxied for D
Ratio of market to book value: proxy for Vl

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Fama & French (1998): Methodology

They have to control for a variety of other factors.

A lot of the variables of interest cannot be measured directly (latent
variables). For example, how would you measure the agency costs of
debt ?
The authors define a number of proxies, all explained in their Section
1. Usually a reference is made to another paper to justify the choice
of the proxy.

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Fama & French (1998): Data

Fama & French use compustat data for 2, 400 firms, from 1965 to
1992.
If you would regress their models for each individual firm in isolation,
you would do time series analysis and only have few observations.
However, by pooling all the 2,400 individual time series together, you
create a panel. In panel data analysis you look for common slope
estimators (bs) across firms
A key advantage of using panel data analysis is that you have way
more data points, and hence more degrees of freedom.

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Fama & French (1998): Main conclusions

Main conclusion: Vl is negatively related to D, inconsistent with the
theory of debt shield
Positive dividends and low levels of debt are associated with higher
firm values.
Potential explanation: dividends and leverage provide information
about firm characteristics (e.g., low leverage may signal management
quality)
Underlying econometric problem: endogeneity problem (we are looking
for the impact of D on Vl , but D may be determined by other factors
that have an independent eect on Vl )

Thus theory might not be wrong, we just do not have a good way of
testing it!

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Part V
Graham (2000)

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Discussion of Graham (2000)

Graham investigates the size of the tax shield on debt.

Key insight: tax savings are less than the one implied by statutory tax
rates dues to the fact that
1

Companies may not be able to fully oset interest agains taxable

income (other tax shields or loss making years)
Personal income taxation (lenders are taxable on their interest payment
which may be higher than the tax on other forms of income)

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Graham (2000): Methodology

Graham focuses on the so-called eective tax rate (etr) to which

firms are subject.
The etr is a function of debt and non-debt tax shields: If a firm
shields o its entire earnings from taxes, its marginal tax rate (mtr)
is zero, and so is the benefit from additional interest deductions.
Hence, Graham postulates Tc is a function of the given level of tax
shields. In section I, he works out the other main assumptions.

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Graham (2000): Data

In section II of the paper the data and variables are described in more
detail.
Graham uses a COMPUSTAT sample for the 1973-1994 period,
giving him 87,643 firm-year observations (in a panel).
Table 1 (p.1914) describes the variables. This is always a great idea
to present before you enter into any analysis.

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Graham (2000): Data (2)

On p.1913 Graham mentions he has winsorized the data for firm

characteristics. Winsorizing is a technique to deal with outliers.
When winsorising (a technique named after the late statistician
Charles Winsor), you replace the extreme values (e.g., lower 5% and
upper 5%) by the next highest or lowest values.
As an alternative, you could trim the data (cutting o the extremes,
but no replacement).
See, e.g., http://en.wikipedia.org/wiki/Winsorising

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Graham (2000): Analysis of conservatism

In section II.B, Graham analyses corporate debt conservatism by
measuring distance from kink in the tax benefit function.
The kink is the point in the tax benefit function where the marginal
benefits decline (because additional interest can no longer be fully
oset).
Idea: firms that operate left of kink are conservative, right of the kink
firms are aggressive
Graham defines a distance to kink as:
(rd D )required to let T c decrease
(rd D )actual
If this ratio is < 1, the firm applies an aggressive debt policy as it
operates in an area where the benefits from the tax shield are already
eroded.
If the ratio is > 1, increasing rd D may still be beneficial (and
indicates debt conservatism).
Figure 1 (p.1908) illustrates this eect for two cases.
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Graham (2000): Analysis of conservatism (2)

Heres the upper part of Figure 1 (p.1908).

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Graham (2000): Analysis of marginal tax benefits

In section III, Graham analyses the real gross corporate tax benefits as
a fraction of total corporate market value. In Figure 2 (p.1919) this is
the centre line (with the stars).
The net benefits are after personal taxes (bottom line).
The upper line shows how much more firms could save on their tax
expenditures if they would gear up to the kink (of course, all under
the ceteris paribus conditions laid out in the intro of the paper).

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Graham (2000): Analysis of marginal tax benefits (2)

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Graham (2000): Main conclusions

First of all, Graham finds the average benefit of the tax deductability
of interest payments adds up to 9.7% of total market value. This is
lower than what is found in other studies (using other indicators).
Second, Graham finds firm using little debt are typically found in the
high growth/few tangible assets sphere. This is cf. all intuition.
Third, Graham estimates to what extent gearing up a conservatively
debt-financed firm would create value. It appears that only very large
increases in the cost of default can justify conservativism (low
leverage puzzle)

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Part VI
Korteweg (2010)

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Korteweg (2010)

This paper nicely illustrates how the field of corporate finance has
advanced over the past year. One of the key claims in Grahams
(2000) paper is that "firms leave money on the table" by
systematically underlevering. Korteweg challenges this by looking at
the dynamic trade-o.
Korteweg finds that firms are on average only slightly underlevered,
relative to their target capital structure. This result is primarily driven
by some true zero leverage firm in the sample. As a consequence,
outliers can be argud to drive the regression result (rather than
systemic underlevering).
The cost of being underlevered is much lower than the cost of being
overlevered.

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Korteweg (2010): Methodology

First, he decomposes the value of the levered firm into
VtL = VtU + Bt (2),
where Bt is the benefit from leverage (incl. tax shield, plus agency
costs associated with e.g. free cash flow problem).
The beta of the levered firm can be written as
bLt =

VtU U
Bt
bt + L bBt (5)
L
Vt
Vt

Korteweg assumes all firms in the same industry have the same asset
beta, bU
Variations in bLt are thus driven by dierences in B (bBt itself can be
estimated).
Looking at firms with dierent leverages L in the same industry, this
allows to identify the B (L)
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Korteweg (2010): Methodology

From estimated values we can derive a B (L) as in Fig.1 of the paper:

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Korteweg (2010): Methodology

It is key to realise that Korteweg does not require that firms are
always optimally leveraged (a problem with earlier studies)
"Trick": while actual L may not reflect target one (because of
adjustment costs), shareprice movements are forward-looking and can
reflect target leverage. Hence b can be used to estimate benefits even
if firm is away from target leverage.

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Korteweg (2010): Methodology

In a dynamic capital structure world, we can identify two costs

associated with L being dierent from the optimum, L :
1
2

The (transaction) cost of moving to L ;

The (opportunity) cost of being away from L .

Wolf Wagner (RSM)

Corporate Finance (BM02FI)

Lecture 1

60 / 64

Korteweg (2010): Data

Korteweg analyses monthly data for two samples:

A sample clustered by 2-digit SIC codes (232 firms, 22 industries;
24,277 firm-month observations);
A sample clustered by Fama & French classifications (290 firms, 30
industries; 29,753 firm-month observations).

Wolf Wagner (RSM)

Corporate Finance (BM02FI)

Lecture 1

61 / 64

Korteweg (2010): Main findings

Underleverage
Firms are on average slightly underlevered (relative to target capital
structure) but this result is primarily driven by some outliers (true zero
leverage firms) rather than by systematic behaviour of firms leaving
money on the table.
The cost of being underlevered is much lower than the cost of being
overlevered! This explains the tendency for lower leverage

Expected leverage changes already reflected in valuations

If a firm has zero debt and pays out dividends, then the market expects
the firm to gear up in the (nearby) future. Expected benefits from
higher leverage are then partially already factored into the current
stock price.

Wolf Wagner (RSM)

Corporate Finance (BM02FI)

Lecture 1

62 / 64

Summary

In this lecture, we have refreshed our knowledge of the Modigliani &

Miller propositions.
We have discussed some work related to these M&M propositions and
the trade-o theory.
With the exception of Modgliani-Miller, the papers are fairly
accessible, so please do start reading.

Wolf Wagner (RSM)

Corporate Finance (BM02FI)

Lecture 1

63 / 64

Summary

In the next class, we analyse the impact of agency problems in the

M&M framework.
Agency problem: There is a separation between the owners (or
principals) and the managers (or agents) hired to run the firm. For
example, managers may have an incentive for empire-building. This
will have implications for the optimal capital structure.
For the next class, please make sure you have read the papers for the
second session.

Wolf Wagner (RSM)

Corporate Finance (BM02FI)

Lecture 1

64 / 64