Don't blame Modigliani-Miller for overleveraging in the corporate world

 An article  in the FT suggests that the Modigliani-Miller Theorem is responsible for over-leveraged companies and the wrecks they have left behind:

Franco Modigliani and Merton Miller both later won the Nobel Prize in economics, partly thanks to their groundbreaking work on what became known as the “M & M theorem”. Until then most companies had assumed that too much debt would affect the value of the firm, so their paper was a counterintuitive bombshell. Their initial findings only held in a world without “frictions” — such as taxes, imperfect information and inefficient markets. But a later revisitation that incorporated the tax-deductibility enjoyed by interest payments showed that the value of an indebted company is actually higher than that of an unleveraged one. It eventually helped lay the intellectual groundwork for a dramatic erosion of corporate creditworthines

I'm afraid the article gets it quite wrong. When they wrote that capital structure is irrelevant to the value of the firm, MM meant there is no particular gain in introducing debt into the capital strucure. Debt increased the return to equity; at the same time the expected return to equity also went up, that is, shareholders expected higher returns of a company exposed to the risk of debt. So, the higher return produced by debt was, in some sense, deceptive. 

The introduction of tax does enhance firm value through the tax shield provided by debt. But this is beneficial only up to a modest level. Beyond that level, the probability of bankruptcy erodes firm value. In other words, firms face a trade-off between the tax shield that debt provides and the increased probability of bankruptcy that it creates. 

In the real world, the most highly valued firms- Apple, Google, Micrososft, Infosys, TCS- are all debt free. They don't think it necessary to enhance shareholder value by injecting debt. There is so much value created through the intelligent deployment and utilisation of assets that tinkering with the liability side is rather redundant. The best managers would adhere to M-M and not resort to debt, certainly not to excessive debt.

In the world of banking, the downside to debt has come to be internalised after the global financial crisis, so banks have raced to give themselves capital far higher than what the regulators have mandated. HDFC Bank has a capital adequacy ratio of 17-18 per cent when the regulatory requirement is under 12 per cent. That is because the markets have come to reward well capitalised banks. It may well be that the valuation of non-financial firms in the markets does not yet reflect the risks entailed by debt. But you can't blame M-M for that.

Of M-M, it could well be said that they came to bury debt, not to praise it.