Debt is cheaper than Equity....not full stop.

This week's lecture was based on the idea that debt is cheaper than equity and a hypothetical optimal mix between them can finance a company. An optimal capital structure maximises shareholder wealth.


Debt is cheaper than equity but DO NOT finance your entire business venture on debt. If debt was cheaper than equity entirely there would be no problem with Portugal borrowing money from the International Monetary Fund or the European Central Bank as it's cheaper than using any equity the Government has left over (which is very little). Borrowing from these institutions lowers a country's economic rating thus making future borrowing for the country more expensive. Debt is not a viable or sustainable financing option.


Modigliani and Miller argue that a firm's value as a business enterprise is independent of how it is financed.
They make assumptions in this theory that no tax is paid and that all knowledge is perfect.
This theory was produced in a business immature environment and these assumptions cannot now be taken in our corporate world. They are simply too big an assumption.


Modigliani and Miller state that the perfect equity/debt mix is within a range of investments. This perfect mix is very changeable with new investments or divestments and would not be worth the company spending time trying to find the optimal mix. This optimal mix was found for a time with the banks prior to the crisis. Each bank was investing in risky ventures that brought bumper results. The debt was never repaid to the retail part of the banks each time. As the lending continued the banks held little capital and when loans were defaulted on the problems started, the capital structure of the bank didn't msw.
The interim report by the Independent Commission on Banking (ICB) has recommended that the banks must have a minimal capital structure of 10%. For every £100 lent out £10 must be held in equity, increasing the Basel 3 standard of 6%. This would prevent another bailout the scale of which we have just seen as it protects savers money. The banks will now have to find an optimal debt/equity mix as their over inflated bonuses will now depend on it.


Ian Gordon from Exane BNP Paribas comments that the ICB's report is nothing more than obvious regulatory 'noise' that they will have to listen to until the final report is published. The comment made in the Guardian (http://www.guardian.co.uk/ 13/04/2011) illustrates them as arrogant, unwilling and misinformed as to the part they played in the crisis. It shows no willingness to evaluate their optimal debt/equity mix because it worked so well before 2008 and the only changes they'll make is if the Government come in with a heavy hand and force them.....which is probably not going to happen due to the political fear that if the banks go overseas it could leave them with no financial future.