I need help poking holes into a discussion where the other guy is leaning heavy on Modigliani Miller. I think it's BS as it supposes a perfect world and completely ignores very big and costly realities like taxes on capital gains among others. Am I off base or are there other arguments I can lean on to poke holes here?

It supposes they aren't hiding anything a la Enron?

Yeah - As I recall (it's been more than a few years since business school, for me), current and future tax policy is ignored, which is a major flaw. I love the simplicity of it, but we've seen fairly significant shifts in taxation of capital gains vs. dividends of late, and even a tax on stock buybacks enacted by the current President. So to ignore these is folly, as they can have a huge impact on investor attraction or repulsion to certain capital strategies. The other obvious flaw is that quantifying future cash flows in absolute is a very speculative venture, not to mention discussion of the correct and proper discount rate to use for the DCF analysis.

I had to look this up - I recognized the phrase but couldn't remember what it was.

As I recall, it basically serves as a control group that lets you quantify the effects of taxes and the debt shield. It doesn't hadn't much value by itself because no markets are taxless and frictionless.

Talon2DSO said:

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I need help poking holes into a discussion where the other guy is leaning heavy on Modigliani Miller. I think it's BS as it supposes a perfect world and completely ignores very big and costly realities like taxes on capital gains among others. Am I off base or are there other arguments I can lean on to poke holes here?

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Rather than arguing it's validity, I think it is more useful to understand this (or any) model for its usefulness and limitations.

If this can be understood well, it is a building block and/or isolation chamber for analysis. Ceteris paribus is almost certainly an invalid condition for real world practicality, but in building a thesis or testing a hypothesis, is a necessary phase.

Am I missing something?

It's been awhile since I was in a theoretical finance course so excuse me as I dust off the cobwebs here, but if I recall MM doesn't have anything to do with your portfolio or capital gains tax. Why are you guys mentioning that?

The core principle that debt and equity mix doesn't matter was wildly inaccurate over the last two decades (because we never imagined prolonged periods with near-zero interest rates that forced such an imbalance). Their argument was that as debt increased, risk to equity holders increased in kind and thus required a higher equity rate of return, nullifying any benefit of income tax avoidance from interest payments.

Now, tax savings are real for firms and at the extremes MM obviously fails, but for most companies in the middle or close to industry averages on debt and equity ratios, I think the theorem provides good guardrails for us, as long as taxation policy is consistent. Taxation clearly supports SOME debt, but an optimal mix still balances rewards from taxes towards risk from interest. It hasn't necessarily changed the theorem, but accounting for taxes just shifts from an indifferent capital structure to an indifferent capital structure as long as you utilize at least XX% debt. MM theorem provides the structure from which we can even calculate the benefit of debt and tax-deductible interest.

Still confused how capital gains or anything like that comes into play. Value of a firm isn't impacted by your capital gains timing and dividends are independent decisions from capital structure. Not sure what you're arguing, OP. Are you trying to split it to debt/equity mix of a portfolio?

Their model held that taxes didn't matter and were therefore excluded. Corporations and individuals could borrow at same rates and to the same degree, transactions are cost less, and on and on.

The underlying assumptions are not correct in the real world and why they are what gets pointed at as the flaw, despite not being the point of their work.

But their model was purely based on enterprise value of the firm. So again, I was confused why anyone was talking about capital gains.

I assume we are talking about the revised M&M theory that takes into account the value of interest tax shields. From what I recall, M&M initially postulated that firms should be completely agnostic to capital structure but quickly realized the real world issues with tax policy. And on that front, if you're working at a sizable company with a lot of debt, you may also need to pay attention to interest expense deduction limitations introduced by the TCJA (section 163j).

Buck Compton said:

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But their model was purely based on enterprise value of the firm. So again, I was confused why anyone was talking about capital gains.

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You are correct in M&M's postulation. I'm speaking to the blind spot it possesses (arguably).

Dividend preference theory exists. Some people prefer dividends and that increases demand for shares of companies with higher dividends. Some prefer growth (i don't know the name of that preference/bias), and don't like dividends.

These differing preferences, along with many other factors, can lead to different discount rates that are appropriate as some investors view risks related to dividends and long-term growth different than others and a differing discount rate is a way to capture the differing perceived risk.

If a different discount rate is used, clearly a different value for the company would exist, invalidating M&M's assertion that taxes are irrelevant.

I think an even more clear example is levered vs. not.

In order for M&M to not include these factors, they have to ignore them. However, they didn't ignore then, they stated them irrelevant or that rational parties are indifferent between them.



Haven't studied/taught this stuff in a while, but I do use the concepts for decision making rubrics on occasion.