The Nobel Prize winners in Economics, Franco Modigliani and Merton Miller had this theory (MM Theorem) that, under certain circumstances, it matters little to the value of the business whether it is financed by equity or debt or any combination thereof.
As Miller explained, by way of an analogy, a firm can be thought of as a gigantic tub of whole milk. The farmer can sell the whole milk as is. Or he can extract the cream it and sell it at a considerable premium to the price of ‘whole milk’.
But then, the farmer is left with skimmed milk that now would sell for a lot less than milk with normal fat content, unless, of course, some slick advertising makes consumers believe that ‘zero fat’ milk is lot more valuable than normal fat milk.
So, if a firm can acquire debt (to finance its operations) at a cheaper price, then it is somewhat akin to a farmer getting more money for the cream. What the firm gains by selling debt cheap, it loses out by having to sell equity at a discount, as investments just became that much riskier. Equity investors would, therefore, demand a risk premium as compensation. In other words, taken together, the value of the firm remains the same, irrespective of whether the firm is financed by debt or equity, or both.
Unaffected value
As a corollary, they argued that, even if a firm chooses to not pay dividends (usually, a red rag to the equity investor bull), but instead ploughs back the internal accruals into the firm, it should not affect the enterprise value.
When a firm ploughs back internal accruals, the transaction can be seen as the firm paying a dividend and getting it back as equity. The value that the firm loses by paying any sum out as dividends is made good by an equivalent amount as equity infusion. In this event, the enterprise value remains constant. Or so the argument goes.
All this, of course, assumes that the firm has a viable business model and, as a consequence, is expected to have a steady stream of cash-flows. It is the capitalised value of such future cash-flows that stands undiminished, despite changes in the financial structure.
Minus this assumption, none of the assertions made in the Modigliani-Miller Theorem would hold. To take an extreme case, if the enterprise value is zero, then no matter how one splits the capital employed in the firm between debt and equity, the value would still be zero.
Cricket example
It is a bit like the gentle ribbing that India’s former cricket captain and country’s opening batsman Sunil Gavaskar experienced at the hands of West Indian cricketer Vivian Richards during the West Indies tour of India in 1985.
Gavaskar had expressed a preference to bat lower down in the order and the Indian team captain Kapil Dev was not very happy about it. The issue had ballooned into a controversy in a cricket-crazy nation, with every commentator worth his name weighing in with his comment. Gavaskar, however, prevailed in the end — he was slotted to bat at number four in the Chennai test match that year.
But, as luck would have it, one of the opening batsmen got out in the second over without a run on the board. The next batsman was out in the first ball and the score still read zero, with two wickets down. In walked Gavaskar at number four, which prompted Richards to chip in with the comment that no matter whichever number Gavaskar came in, the score was still zero!
Which means, if the enterprise is worth nothing, then any amount of tinkering with the combination of debt and equity isn’t going to change anything. The value would still be zero.
Cut to present
Which is why, it is a bit of surprise that the International Monetary Fund (IMF) said it wouldn’t be a bad idea for banks to convert monies lent to problem borrowers, into equity.
In typical bankerspeak, the IMF has said in one of its recent publications: “A decision to convert a senior (and possibly secured) claim into the most junior security in a firm should be taken only in cases where the upside for the bank is clearly large and there is a high probability that the firm’s equity stake will be sold in the near future. This requires an ex-ante assessment of business solvency (true economic value of its assets as compared to liabilities) and viability (ability to generate an economic surplus)”.
In plain English, this means the Brettonwoods institution is saying one could convert debt into equity where there is a possibility of such an equity being sold at some future date at a huge profit to the original value. Therein lies the catch. It is virtually impossible to say, with any great degree of certainty, that the future looks a lot rosier than the present, when such an assessment is made at the time of initial grant of the loan.
Also, there is no guarantee that a management that has made a mess of things the first time around would have learnt its lesson and will do things differently the next time. But the Reserve Bank of India, which has a scheme for Indian banks to handle their loans, thinks it has an answer to the second problem.
Counter notions
The RBI version is labelled ‘Strategic Debt Restructuring (SDR), which stipulates that the quantum of conversion of loans into equity should be of a size that confers on the bank a majority stake in the firm. But then, this runs counter to another deeply held notion that banks shouldn’t stray away from their core business of lending.
The stake in the troubled business, that forms part of the bank’s investment portfolio, has to be sold to a prospective buyer. But finding a buyer within a reasonable period of time is not going to be easy, more so when the business is far from having established itself on a firm footing. A recent news report spoke of the travails of one such bank with regard to its exposure to a borrower in the steel industry.
Little would those prize-winning economists have known that 50 years after they first put forth the proposition, policymakers in India and elsewhere would put to perverse test the irrelevance of the debt-equity combination in a firm’s capital structure.
Yet that is what these recent gyrations in dealing with problem loans of banks amount to. Banking is about making a series of decisions and some of them, by their very nature, are bound to be flawed. The trick is to reconcile oneself to the situation and move on. That elementary lesson seems to have escaped policymakers.