TITLE:
Can Business Firms Have Too Much Leverage? M&M, RJR 1990, and the Crisis of 2008
AUTHORS:
William Carlson, Conway Lackman
KEYWORDS:
Corporate Finance, Leveraged Buyouts
JOURNAL NAME:
Modern Economy,
Vol.7 No.2,
February
24,
2016
ABSTRACT: In 1958 Modigliani and Miller published one of the most significant
papers in finance on the cost of capital. It presented the capital structure
irrelevance theorem which states that the cost of capital is independent of
capital structure. It implies that there is no optimal structure and
consequently denies the existence of non-optimal structures. If there are no
non-optimal structures then there is no such thing as a business firm having
too much leverage or debt. We disagree with that conclusion on both theoretical
and empirical grounds supported by the evidence provided by the Financial Crisis
Inquiry Commission plus the basic logic behind Basel III. The model of this
paper comes from Brigham and Houston’s Bigbee case using beta, the Hamada
transformation and an interest rate function which is crucial, concepts not
available to M&M in 1958. We show how the minimization of WACC (weighted average cost of capital)
and maximization of stock price give identical solutions and their similarity
to M&M Propositions I and II. It also shows the simple mechanism that
causes non-optimality. M&M missed non optimal structures partly because
their data base from 1948 and 1953 had only low and moderate debt/equity
ratios. Non-optimal behavior appears at high (double digit) D/E ratios. We have
examples of the consequences of excessive leverage not available to M&M,
including RJR, Houdaille Industries, the casualties of the 2008 crisis and
others. The RJR LBO is examined in detail because it is as close to a
laboratory experiment as can be expected in economics. The analysis shows how
extremely high leverage put RJR on the path to bankruptcy and how the
Roberts-Gerstner plan restored profitability following the logic of Brigham’s
Bigbee model.