Sunday 14 July 2019

Economic Myths: Miller & Modigliani Theorem

The first part of the original M&M Theorem makes perfect sense:

The Modigliani-Miller theorem (M&M) states that the market value of a company is calculated using its earning power and the risk of its underlying assets and is independent of the way it finances investments or distributes dividends.

There are three methods a firm can choose to finance: borrowing, spending profits (versus handing them out to shareholders in the form of dividends), and straight issuance of shares. While complicated, the theorem in its simplest form is based on the idea that with certain assumptions in place, there is no difference between a firm financing itself with debt or equity.


So far so good. If the value of the business is more than the outstanding debts, then the shares have value; if the debts exceed the value, then the shares are nigh worthless. The total value of debts + shares remains roughly the same. The value of the bonds can't exceed value of the business and the value of the shares can't go lower than zero.

If you aren't sure whether to buy shares or bonds in a company, the best strategy is to have a mix. For example Mike Ashley/Sports Direct spent £150 million on acquiring 30% of the shares in Debenhams. Unfortunately for him, the debts ballooned to far more than the value of the business, so the lenders took over the business and his shares were wiped out (a kind of debt for equity swap).

His better strategy would have been to spend less on shares and more on acquiring Debenhams debts pro rata (say 15% of each). If the business had done well, his shares go up in value and if it does badly, his shares are wiped out but he still ends up with 15% of the business in his capacity as lender.
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What's nonsense is the related claim that the tax system encourages businesses to borrow money instead of issuing shares:

Third, the use of debt is less expensive than the use of equity because debt is generally subsidized by the state through the tax system –since debtors can deduct the interest payment associated with the use of debt. Therefore, the use of debt may reduce the firm´s cost of capital.

That's a generalisation across many countries' corporation tax systems, but whether it is true or not depends on the rates of tax applied to corporate profits (at corporate level) and dividend and interest income at shareholder/lender level.

(I started as a tax adviser in 1989 and had to advise clients on 'what is better for tax', the answer depended on the circumstances. I later did an accounting and finance degree, and the lecturer trotted out the M&M tax drivel and would simply not listen to reason and logic.)

IIRC and generalising a bit, Singapore and Hong Kong governments get so much money from land rent, land auctions, stamp duty and capital gains on land that they barely need to bother with taxing incomes. So companies pay 15% corporation tax and individuals pay 15% income tax. If an individual gets a dividend, it is treated as tax paid, so no further income tax due. If an individual receives interest income, it is taxed at 15% so it is as broad as it is long.
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In the UK, we had a brief period in 2012 or thereabouts (before Osborne started messing things up again), when it simply did not make a difference for corporation tax/income tax (ignoring National Insurance, which clearly distorts things, the 45% additional rate and overseas stuff).

The rates were:
Corporation tax - 20%
Basic rate income tax - 20%
Higher rate income tax - 40%
Withholding tax on interest - 20%.

* If a basic rate taxpayer received a dividend, there was simply no more tax to pay (same as Singapore or HK) because the company had already paid 20%. (Ignore the bullshit with the 10% tax credit and the 10% nominal rate, it worked out at nil, unsurprisingly).
* If a basic rate taxpayer took a salary bonus, the employer took 20% income tax via PAYE and the employee had no more income tax to pay.
* If a basic rate taxpayer received an interest payment, the company paid over 20% withholding tax/income tax on a CT61 and the individual had no more tax to pay.

* If a higher rate taxpayer received a dividend, he had to pay 25% income tax on the dividend, so the overall rate was 40%. Remember - company earns £100, pays £20 corporation tax, pays £80 dividend, individual pays £20 income tax and nets £60. (Ignore the bullshit with the nominal 10% tax credit and the 32.5% nominal rate, it worked out at 25%).
* If a higher rate taxpayer took a salary bonus, the employer took 40% income tax via PAYE and the employee had no more tax to pay, net pay £60.
* If a higher rate taxpayer received an interest payment, the company paid over 20% withholding tax/income tax on a CT61 and the individual declared the gross amount and paid a further 20% of the gross amount, net interest £60.

Osborne and Hammond then busily messed up this state of affairs and now you have to do the three calculations each time to see 'what's best for tax'.
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There are lots of other wrinkles...

* Pension funds can receive interest or rent truly tax-free, but receive dividend payments out of after-tax income. It would make more sense to tax all sources at a flat, lower rate, so that they get some refund of the corporation tax on dividends but pay some tax on interest and rental income.

* Some companies have large tax losses (R&D tax credits, Film Tax Credits etc) but have distributable commercial profits, so are advised to pay dividends so that shareholders get the (slightly) lower income tax rate that applies to dividends.

* Some companies don't have distributable commercial profits, so aren't allowed to pay dividends, but can still pay salary bonuses or interest.

In a perfect world, therefore, dividends, interest, rent and wages would be taxed exactly the same way i.e. there would simply be a flat withholding tax at the same rate on each when the company pays them out.

We used to do this for dividends (Advance Corporation Tax);
Banks used to withhold 20% income tax from deposit interest;
Non-banks still have to do it for interest payments (CT61s);
PAYE applies to wages;
CIS deductions apply to sub-contractors in the construction industry;
and tenants with non-resident landlords are supposed to, by default, pay 20% of the rent to HMRC and pay the landlord the balance of 80% (though most wriggle out of this).

You wouldn't even need to bother having special rules for foreigners and there would be no need to distinguish whether it's wages, rent, dividends, interest, sub-contractor payments etc. It could all be included on one return/reporting system and paid to HMRC in one payment. As a final flourish, dividends paid net of tax would be an allowable expense for corporation tax purposes.

Individuals who have to submit income tax returns (i.e. higher rate taxpayers) can then just enter all 'net of tax' payments in one box and pay the same tax rate on the lot, minus the credit for income tax withheld at source.

Here endeth.

16 comments:

Lola said...

I bet the 'Office for Tax Simplification' would be horrified if you told them all that. As would lots of tax advisers, who know it already...

Mark Wadsworth said...

L, the OTS are disappointingly timid.

Dinero said...

Look at the case of considering new spending and new funding from new money acquired from outside of the firm. The figure for Profit distributed to current share holders or spent on new projects of the firm. That figure is net of corporation tax and net the cost of funding. The cost of funding that spending is debt interest on new debt or dividends on new shares sold to new share holders. Debt interest payments are deducted from the profit figure before the corporation tax figure is calculated, and so the cost of debt interest payments leave the figure for profits net of corporation tax and funding larger, compared to the cost of new dividends payments to new share holders. So current share holders deciding on how to acquire new money from outside of the firm have an incentive to take on new debt to acquire money rather than sell shares to new share holders to acquire money. The profit is distributed to themselves or spent on new projects of the company.

Graeme said...

I remember this m and m stuff and thinking how simplistic it was... And there were about a dozen assumptions that had to hold in order for it to work. So it was an interesting theoretical construct but not easily applicable in practice. The last few budgets have complicated things to an absurd degree, the dividend allowance that isn't an allowance, property income dividends taxed differently from normal dividends from the same company! Who dreams up these things?

Dinero said...
This comment has been removed by the author.
Dinero said...

Simple case,
Bob the Builder wants to buy a van. he can sell a £100 bond with a £10 coupon or he can sell a share for £100 with a £10 dividend. If he sells the bond the £10 is deductible for tax and Bob gets more revenue for himself after tax.

Mark Wadsworth said...

Din, your first comment is full of errors. Primarily, businesses invest out of PRE-TAX profits. The more they invest, the less tax they pay. Corporation tax is only paid on profits which are NOT reinvested i.e. not needed to maintain or increase capital base.

Second one is easier to debunk.

1. Corporate bond yields are slightly higher than dividend yields. So Bob can borrow at 10% or issue shares promising (but not guaranteeing) 8%.

2. Bob gets a full corporation tax deduction for £100 cost of new van in the first year. The tax relief on the interest is pretty irrelevant.

3. If Bob borrows, he HAS to pay 10% interest each year whether he likes it or not, reducing the amount he can reinvest in the business. If Bob issues shares, he won't start paying dividends until the business is throwing off free cash and there's nothing else worth investing in.

4. So Bob's choice is pay £10 interest with £2 tax deduction from Day One or start paying £8 dividends in a couple of years when the business is up and running.

Why would Bob prefer to borrow?

G, the first bit of M&M makes sense, give or take a bit and in round figures. It's the tax part that is bullshit.

Dinero said...

Whatever the dividend payments or interest payments are, or what the flexibility of the dividend payments is, the pertinent point is there are incentives for each option without corporation tax , but with corporation tax the incentive to use the debt option increases because that option increases the revenue to Bob.

Mark Wadsworth said...

D, it doesn't. The after tax cost of dividends is the same as the after tax cost of debt. Otherwise, why aren't all companies 99% debt financed?

Ralph Musgrave said...

Another application of M&M is to the "full reserve banking" idea. FR is the idea that all bank loans should be funded via equity rather than deposits. That way, bank failures are impossible.

Opponents of FR often claim that would increase the cost of funding banks. FR supporters (like me) answer that with "M&M": i.e. the idea that the cost of funding a bank, or indeed any corporation, is not influenced by the % of funding coming from equity rather than debt.

Certainly M&M would seem to be valid there. That is, those funding a corporation obviously charge for risk undertaken. The risk run by shareholders is obvious enough. In the case of bank depositors, the risk is run by the government run deposit insurance system, and there's no obvious reason why the risk is any different for those two types of funders.

Certainly the % of funding for non-bank corporations that comes from equity versus debt varies widely: e.g. Google is 90% funded via equity. That does not seem to do Google any harm.

Mark Wadsworth said...

RM, yes exactly. A point I made myself when bank funding was a hot topic.

Lola said...

There aught to a price for the risk of equity over FI. And there is!! Generally shares return more than FI for investors. This does not of course mean that equity finance costs the firm more than debt finance.

Mark Wadsworth said...

L, all depends on the business and overall risk. By and large, bond holders get better annual yield, but no capital gains. Shareholders get lower annual yields but hope for capital gains.

Dividends are fixed by the company, share prices adjust up or down to give required yield.

Lola said...

MW. Yes. But. It used to be that shares yielded more than bonds - as they were more risky. Up until post WW2. Ross Goobey was one of the very first investment managers to spot that inflation would reverse that and increased his share weightings. That is shares are shares of real assets and they hence give a bit of a hedging opportunity for inflation.

If you look at the research (Fama and French et al) equities in one way or another have always demonstrated a risk premium over FI.

There are also risk premiums for smaller companies and 'value' companies. And shorter dated bonds are less risky than longer dated ones. Overall there is very little additional return for risk for holding bonds with a duration to maturity longer than about 2 to 3 years.

But this is all OT.

Dinero said...

Maybe the corporate bond yields are slightly higher than dividends because the corporate bond interest payments are tax deductible and so the cost to the corporation paying the dividends or interest after tax is the same.


MandM on bank equity is that increasing the equity portion of the liabilities need not increase the cost of funding because the risk weighted return to the equity holder is the same for any size of equity layer. ie the risk to a small equity layer is high because it is exposed to even a small fluctuation in the assets a larger layer is less exposed , and so MandM says that the dividends per share can be reduced because returns to each share is the same after risk weighting.

Mark Wadsworth said...

L, yes, it used to be different and it's different for different companies. But as you say, OT.

Din, in real life it all cancels out and the tax system does not materially affect the debt to equity ratio.