Debt Doesn’t Matter
After a baseball game one night, Yogi Berra was asked into how many pieces he wanted his pizza cut. He said,”Four. I don’t think I can eat eight.” Miller and Modigliani hypothesized that the amount of debt versus equity has no relevance to the value of the firm. Simply speaking: debt doesn’t matter. No matter how you cut the capital pie, the size of the pie (i.e., firm value) does not change by making the debt piece bigger (i.e., leveraging the firm).
Although the perfect capital market assumption, which is basic to this argument, is a bit of a stumbling block, the irrelevance theory of debt has a certain charm and plausible logic. The value of the firm is determined by the market value of the free cash flows generated by the assets, and the financing shenanigans of wall street and corporate “do-gooders” just do not matter.
To the extent that leverage increases the returns to the shareholders, the increased risks associated with greater debt reduce the value of the returns to shareholders commensurately; thus, the size of the pie does not change.
Debt doesn’t matter.
Posted on Sun, April 11, 2010
by Timothy E. Moffit