No Magic in Financial Leverage

MM’s propositions boil down to the simple warning: There is no magic in financial lever­age. Financial managers who ignore this warning can be sucked into practical mistakes. For example, suppose that someone says, “Shareholders demand—and deserve—higher expected rates of return than bondholders. Therefore, debt is the cheaper source of capital. We can reduce the average cost of capital by borrowing more.” Unfortunately, that doesn’t follow if the extra borrowing leads stockholders to demand a still higher expected rate of return. According to MM’s proposition 2, the cost of equity capital, r_E> increases by just enough to keep the weighted average cost of capital constant. Thus, there are actually two costs of debt. One is the interest rate that lenders require; the other is the higher return that equityholders demand to compensate them for the extra risk resulting from leverage. Mistakes arise when you ignore this second cost.

This is not the only logical short circuit that you are likely to encounter. We have cited two others in Problem 6 at the end of this chapter.

Few financial managers believe that the company cost of capital can be reduced by higher and higher leverage. But is it possible to stake out an intermediate position, in which a moder­ate degree of leverage increases the expected equity return, r_E, but by less than predicted by MM’s proposition 2? In this case, there would be an optimal amount of leverage that mini­mizes the weighted average cost of capital.

Two arguments could be advanced in support of this position. First, perhaps shareholders do not notice or appreciate the financial risk created by moderate borrowing, although they wake up when debt is “excessive.” If so, stockholders in moderately leveraged firms may accept a lower rate of return than they really should.

That seems naive.^[2] The second argument is better. It accepts MM’s reasoning as applied to perfect capital markets but holds that actual markets are imperfect. Because of these imper­fections, firms that borrow may provide a valuable opportunity for investors. If so, levered shares might trade at premium prices compared with their theoretical values in perfect markets.

Suppose that corporations can borrow more cheaply than individuals. Then investors who want to borrow should do so indirectly by holding the stock of levered firms. They might be willing to live with expected rates of return that do not fully compensate them for the business and financial risk they bear.

Is corporate borrowing really cheaper? It’s hard to say. Interest rates on home mortgages are not too different from rates on high-grade corporate bonds.^[3] Rates on margin debt (bor­rowing from a stockbroker with the investor’s shares tendered as security) are not too different from the rates firms pay banks for short-term loans.

However, suppose that there is a large class of investors for whom corporate borrowing is better than personal borrowing. That clientele would, in principle, be willing to pay a pre­mium for the shares of a levered firm. But maybe it doesn’t have to pay a premium. Perhaps smart financial managers long ago recognized this clientele and shifted the capital structures of their firms to meet its needs. The shifts would not have been difficult or costly. But if the clientele is now satisfied, it no longer needs to pay a premium for levered shares. Only the financial managers who first recognized the clientele extracted any advantage from it.

Maybe the market for corporate leverage is like the market for automobiles. Americans need millions of automobiles and are willing to pay thousands of dollars apiece for them. But that doesn’t mean that you could strike it rich by going into the automobile business. You’re at least 100 years too late.

1. Today’s Unsatisfied Clienteles Are Probably Interested in Exotic Securities

So far, we have made little progress in identifying cases where firm value might plausibly depend on financing. But our examples illustrate what smart financial managers look for. They look for an unsatisfied clientele, investors who want a particular kind of financial instru­ment but because of market imperfections can’t get it or can’t get it cheaply.

MM’s proposition 1 is violated when the firm, by imaginative design of its capital struc­ture, can offer some financial service that meets the needs of such a clientele. Either the service must be new and unique or the firm must find a way to provide some old service more cheaply than other firms or financial intermediaries can.

Now, is there an unsatisfied clientele for garden-variety debt or levered equity? We doubt it. But perhaps you can invent an exotic security and uncover a latent demand for it.

In the next several chapters, we will encounter a number of new securities that have been invented by companies and advisers. These securities take the company’s basic cash flows and repackage them in ways that are thought to be more attractive to investors. However, while inventing these new securities is easy, it is more difficult to find investors who will rush to buy them.

2. Imperfections and Opportunities

The most serious capital market imperfections are often those created by government. An imperfection that supports a violation of MM’s proposition 1 also creates a money-making opportunity. Firms and intermediaries will find some way to reach the clientele of investors frustrated by the imperfection.

For many years, the U.S. government imposed a limit on the rate of interest that could be paid on savings accounts. It did so to protect savings institutions by limiting competition for their depositors’ money. The fear was that depositors would run off in search of higher yields, causing a cash drain that savings institutions would not be able to meet. Interest-rate regula­tion provided financial institutions with an opportunity to create value by offering money market funds. These are mutual funds that invest in Treasury bills, commercial paper, and other high-grade, short-term debt instruments. Any saver with a few thousand dollars to invest can gain access to these instruments through a money market fund and can withdraw money at any time by writing a check against his or her fund balance. Thus, the fund resembles a checking or savings account that pays close to market interest rates.^[4] These money market funds became enormously popular. At the peak of their popularity in 2008, they managed $3.3 trillion of assets.

Long before interest-rate ceilings were finally removed, most of the gains had gone out of issuing money-market funds to individual investors. Once the clientele was finally satisfied, MM’s proposition 1 was restored (until the government creates a new imperfection). The moral of the story is this: If you ever find an unsatisfied clientele, do something right away, or capital markets will evolve and steal it from you.

This is actually an encouraging message for the economy as a whole. If MM are right, investors’ demands for different types of securities are satisfied at minimal cost. The cost of capital will reflect only business risk. Capital will flow to companies with positive-NPV investments, regardless of the companies’ capital structures. This is the efficient outcome.

Source:  Brealey Richard A., Myers Stewart C., Allen Franklin (2020), Principles of Corporate Finance, McGraw-Hill Education; 13th edition.