Other than his cool name I have a lot to say about this guy  And guess what, it’s all good. Here is what I like about Franco Modigliani He was smart. · He confronted Wall St. with it’s own stupidity, and they just called him names. · He’s got a great Italian name. · He figured out what the optimal capital structure is……nice work Franco. 100% Debt –
The Optimal Capital Structure? - Of Course it is! If you can get
someone to lend you money for a risky project at a fixed rate….you should do it
until you have all of their money, then invest it and allow all the value
accrue to equity beyond their fixed rate.
Don’t forget to immediately pay
yourself 100% of the equity out in dividends constantly otherwise your capital
structure would be inefficient.
Be honest, tell them the truth about what you are doing and if it works you win and they win, if it doesn’t your equity risk is equal to 100% of zero…..This is called getting something for nothing and guess what….You can’t do that! (see Tim’s Commandments)…..this is all that investment banks do and look how tall their skyscrapers are! By my reckoning, the Modigliani Miller propositions (as extended) had been the most criticized piece of economic thought ever. That was of course until Nassim Taleb called Harry Markowitz and his MPT the work of a charlatan devil beset upon reclaiming his ancestral home in the Levantine highlands.
Sidebar on Harry Markowitz: My suggestion is that we give Dr. Markowitz a break. I had lunch with him the other day on a sunny afternoon in San Diego. Naturally the mud that was being thrown at him came up in the discussion, and I was struck by the contrition of his answer. He is aware that some of his thought led to the near downfall of western civilization, but much like Alfred Nobel (the inventor of dynamite who was no stranger to the pernicious effects of his creation) he created something that was useful for a long period of time stop bashing him! Go bash Euclid and his simple geometry with it’s flat lines and smooth curves! RIP Beniot Mandelbrot.
| Proposition I: where § VL is the value of a levered firm. § VU is the value of an unlevered firm. § TCD is the tax rate (TC) x the value of debt (D) § the term TCD assumes debt is perpetual This means that there are advantages for firms to be levered, since corporations can deduct interest payments. Therefore leverage lowers tax payments. Dividend payments are non-deductible. Proposition II: where · rE is the required rate of return on equity, or cost of levered equity = unlevered equity + financing premium.
The same relationship as earlier described stating that the cost of equity rises with leverage, because the risk to equity rises, still holds.
The formula however has implications for the difference with the WACC. Their second attempt on capital structure included taxes has identified that as the level of gearing increases by replacing equity with cheap debt the level of the WACC drops and an optimal capital structure does indeed exist at a point where debt is 100%
See, it’s pretty simple if you can get it done!
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