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Appendix to EMP and MM

The efficient market hypothesis originated in 1953 when Maurice Kendall, a British statistician, presented a paper to the Royal Statistical Society on the behaviour of stock and commodity prices. In the statistical research he conducted, he discovered that rather than stocks and commodities going through cyclic price ranges, the reverse was actually true. What he found was that the prices of stocks and commodities were quite random from one week to another, and this lack of correlation was termed ‘random walk’ because the changes in price were independent (Brealey et al, 2006).

Eight years later in America, Eugene Fama expanded upon Kendall’s initial assessment when his PhD thesis concluded that stock price movements are unpredictable and follow a random walk. This work, entitled “The Behavior of Stock Market Prices”, was published as the entire January 1965 issue of the Journal of business. Fama went on to conduct an event study that sought to analyse how stock prices respond to an event. The theoretical and empirical studies that Fama conducted eventually led him to write an article entitled, “Efficient Capital Markets: A Review of Theory and Empirical Work”. Which was published in the May 1970 issue of the Journal of Finance, was a groundbreaking work because it gave birth to the efficient market hypothesis Fama proposed three levels of efficiency, which are distinguished by the degree of information reflected in the security prices; weak, semi-strong, and strong (Wikipedia, 2007).

In the weak form of market efficiency, share and commodity prices reflect the information contained in the record of past prices. In this type of efficiency, it is impossible to make consistently superior profits by studying past returns because the prices will follow a random walk (Brealey et al, 2006).

In the semi-strong form of efficiency, the share and commodity prices reflect past prices and all other published information. In this type of efficiency, prices will adjust immediately to the public information made available (Brealey et al, 2006).

In the strong form of efficiency, share and commodity prices reflect all available information that can be acquired by painstaking analysis of the company and economy in general (Brealey et al, 2006).

In his work, Fama defined an efficient market as one in which prices always ‘fully reflect’ available information and stated sufficient conditions for market efficiency as being: (i) no transaction costs in trading securities, (ii) all available information is costlessly available to all market participants, and (iii) all agree on the implications of current information for the current price and distributions of future prices of each security. His statements indicated that a market is called ‘efficient’ if investors who possess information nevertheless earn only a competitive expected return from investing in a particular company (University of Leicester, 2007).

Arbitrage is an important concept when considering the efficient market hypothesis. In the field of economics, arbitrage is defined as the practice of taking advantage of price differentials between two or more markets: matching deals are struck that capitalise on the imbalance in the market, and the profit is the difference between the two market prices (Wikipedia, 2007).

A very simple example of the arbitrage process is to find two identical items that have different prices. The most profitable thing a businessperson can do would be to purchase the lower priced item and then sell it at the higher price. His profit would be the difference between the two items, less the cost incurred in transporting it to the new location.

To illustrate the concept of arbitrage, take an everyday example that has actually happened in Reading, but could happen in any town:-

	A market in Tilehurst, Reading sells a necklace for £3.	
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	The independent market trader sees the £3 necklace in Tilehurst, Reading, and purchases it.	
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	The independent market trades goes to Foster Wheeler, a company on the outskirts of Reading where there are no shops available, and arranges to set up a stall during lunchtime.  	
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	The independent market trader removes the £3 tag from the necklace and replaces it with his own £15 tag.	
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	A busy piping engineer, on his lunch break, notices the necklace for £15.  Remembering that he has to buy a present for his wife, and not having time to travel to Reading town center, he purchases the £15 necklace.	
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	The independent market trader makes a gross profit of £12, which is the difference between the £3 he originally purchased the necklace for and the £15 he re-sold it for.  	
 

Although the illustration above is quite simplistic, the process by which it has been explained can quite easily be analogous to how an investor in the capital market would go about making a profit in dealing in shares and commodities. Any profits, however, are likely to be short-lived because the efficient market hypothesis will not allow for such variances in price to last indefinitely.

Modigliani and Miller showed that in practice, two companies that had the same degree of business risk but differing weighted average cost of capital (WACC) would not stay in disequilbrium for long. The reason for this is because the arbitragers would move into the market and sell shares in the company that had the lower value expected return required for the business risk of the company’s assets (KO) and purchase shares in the company that had a higher return on their investments, thereby achieving a profit. Investors would continue to trade until the WACCs of the two companies balanced out. Once the WACCs of the two companies equaled, or the expected rate of return of an investment was the same, no further gains could be made, so the arbitragers would cease trading and move on to another market where disequilibrium exists (Lumby and Jones, 2003).

After Kendall presented his presentation on the random walk of the stock market and before Fama wrote about that efficient market hypothesis, Franco Modigliani and Merton Miller were hard at work developing ideas of their own. In the 1958 edition of the American Economic Review, what has now become the Modigliani-Miller theorem appeared in a seminal article entitled, “The Cost of Capital, Corporation Finance, and the Theory of Investment.” So much has been written about this theory that it is believed to be the single work that turned the study of finance into a separate discipline (Poulson, 2006).

In its basic form, the Modigliani-Miller theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm’s capital is raised by issuing stock or selling debt, and it does not matter what the firm’s dividend policy is (Wikipedia, 2007). The Modigliani-Miller theorem, therefore, can be broken down into two basic precepts: capital structure and dividend policy.

Capital structure is defined as the way companies finance themselves through a combination of equity capital and debt capital. Equity capital is generally considered to be options, bonds, and stocks, and individuals who purchase equity capital are considered to be part owners of the company and will therefore have a say in how the company is run. Debt capital, on the other hand, is loans that the business takes out and the owners of debt capital generally do not have a say in how the company is run. A company can either be financed by all debt capital, all equity capital, or a combination of the two.

There are several advantages of using debt capital instead of equity capital. Owners of debt capital are merely creditors and do not have any ownership of the company. When the debt is repaid, it is said to be redeemed, and the lender no longer has any stake in the company. Suppliers of debt capital are contractually entitled to receive an annual percentage return, or coupon rate, on their loan, which must be paid before any dividends can be paid out to the shareholders. Because the payment of interest takes priority over the payment of dividends, debt capital carries with it less risk than equity capital (Lumby and Jones, 2003). In many countries, companies are allowed to offset the debt interest against their corporation tax liability, so debt interest is essentially tax-free and is subsidized by the government. Equity capital, in contrast, is taxed twice: the company must pay corporation tax on its profits before the dividends are paid to the shareholders, and the recipients of these dividends must also pay capital gains tax.

When considering what kind of capital structure a company should employ, it is always important to consider the level of gearing it is able to accept. Gearing, or leverage, is defined as the ratio of total market value of a company’s debt capital to the total market value of its equity capital. The formula for gearing, which is called the debt to equity ratio, is expressed as:-

If the debt to equity ratio is high, this indicates the company has been aggressive in financing its growth with debt. The higher debt to equity ratio, or the more debt a company incurs, the higher the risk that will be borne by the shareholders. Because the shareholders are taking a greater financial risk, they in turn will expect a higher return on their investment, so the cost of equity capital will also rise. Therefore, an increase in gearing will lead to an increase in financial risk, which will lead to an increase in the cost of equity capital. This relationship can be visually explained as:-

The weighted average cost of capital (WACC) is an important term to consider when deciding upon which capital structure to employ within a company. The WACC is a weighted average of all of the costs of the individual components of the company’s capital structure. In writing, the algorithm is expressed as:-

Dividend policy, although the least analysed and most elusive area of decision-making is nevertheless a very critical factor that must be taken into consideration when determining a company’s investment and retention of wealth. While the firm’s investment decision is what has the potential to create new wealth for the shareholders, the dividend policy can play a useful role in informing the market about earnings growth opportunities envisaged by management (University of Leicester, 2007).

The Modigliani-Miller theorem has spurred the dividend irrelevance proposition, which avers that it makes no difference what dividend policy a company might pursue because it is merely another way of looking at earnings retention. The reason for this is because the different methods of equity financing are equivalent on shareholder’s equivalent wealth. To illustrate this point, if equity earnings are retained to finance profitable investment, the shareholders benefit from an increase in the share price. If on the other hand, a company decides to finance a project through the sales of new shares at their full value, the shareholder will receive a larger dividend but a smaller capital gain (University of Leicester, 2007). This point is illustrated in Annex B, using Gordon’s version of the basic dividend valuation growth model (Lumby and Jones, 2003).

There are two ways that companies can pay out cash to their shareholders; they can pay a dividend or they can buy back some of the outstanding shares. In addition, some companies don’t pay dividends in the form of cash, but issues stock dividends instead, which has the effect of increasing the number of shares while the value of the company remains the same, thereby decreasing the value of each share. Instead of paying out a dividend, a company may choose to use the cash that it would have used to pay its shareholders to repurchase stocks, which will be stored in the company’s treasury and resold if necessary (Brealey et al, 2006).

Market capitalization is an important concept when considering dividend policy. It is defined as the total value of all outstanding shares in a company. It is calculated as the number of outstanding shares times the current market price of a share. Therefore, it there is 1,000 outstanding shares and each is valued at £10 then the market capitalisation would be:-

The table in Annex B illustrates the dividend irrelevance proposition first discussed by Modigliani and Miller. Company A has a market capitalisation of £9,000, which is its value. It has 9,000 shares outstanding, and these shares are valued at £1 each. It makes the decision to pay out dividends on one-third value of the shares, which means that £3,000 will be paid out in dividends. The decision is made to finance the payment of dividends by selling more shares. It must therefore sell new shares at a value that will maintain the value of the firm and pay a dividend of £3,000. 4,500 shares are sold at a value of £.67, which will bring £3,000 into the company that can be given to the shareholders as a dividend. The value of the firm will remain constant at £9,000, but since there are now 13,500 shares instead of 9,000 shares, the value of the shares has decreased by one third. Therefore, while the value of his shares have decreased by one third, he was given a dividend of one third the value of his original shares, so he was not out of pocket.

Alternatively, the company may decide to issue new stock in lieu of paying dividends. In that instance, they would sell 4,500 new shares, which would decrease the value of the stock by one third, but increase the stock by a ratio of 3:2.

In order to refresh the reader’s memory about the original purpose of this paper, the opening statement made was, “If the capital market is efficient, there is no need to spend time on setting a particular structure and dividend policy for a listed company. The statement can be broken down into two distinct topics; the first being the relevance of capital structure, and the second being the relevance of the dividend policy.

The Modigliani- Miller theorem makes the assumption that it does not matter if a company is financed with debt capital or equity capital, and all things being equal, it would be better to finance the company with debt capital (Lumby and Jones, 2003). While in theory it would be permissible for companies to finance themselves solely with debt capital, in practice this is rarely the case. There are many reasons why companies do not solely obtain their finance using debt capital, to include tax implications, bankruptcy costs, and agency fees. Most companies’ financial structures are designed so that no more than 50% of their capital is financed by incurring debt, with the average debt capital financing being 25%. In addition, the higher the level of gearing that is used, the greater the risk is that the company might default on the loan. It is for this reason that the institutions that lend money often impose legally binding covenants before granting a loan. The may insist the company keep their gearing down to a certain level, and if the company breaks those conditions, the lender will be entitled to ask for immediate repayment of the loan (ICAEW, 2005). The debt holder may also restrict the amount of dividends that are paid to the shareholders, or the may restrict management from disposing of major assets without the debt holder’s agreement (Lumby and Jones, 2003).

The dividend irrelevance hypothesis follows the same line of thought as the capital structure hypothesis: the Modigliani-Miller theorem states that it makes no difference what kind of dividend policy a company decides upon because dividend policy is simply another way of looking at earnings retention (University of Leicester, 2007).

There are three ways that a company can distribute wealth; (i) interest payments to suppliers of debt capital, which are determined by a company’s capital structure, (ii) dividend payments to shareholders, and (iii) retention in the company for application to investment opportunities. The dividend irrelevance hypothesis states that whether or not a shareholder receives a dividend is irrelevant because his wealth will be the same nevertheless. If he receives the dividend then he will receive cash as a return on his investment. If he receives extra shares instead of a dividend, those extra shares will be equivalent to the dividend he would have received. If the company decides not to issue dividends at all, but to re-invest the money into a new project, the value of his shares will subsequently increase to the amount he would have received if he had received a dividend. Either way, the shareholder wealth will remain the same.

Many tax regimes give the typical shareholder lighter taxes on capital gains, the selling of shares, then they do dividends. Tax considerations, therefore, are an incentive for companies to reduce dividend payments and re-invest the money into internally financed ventures (University of Leicester, 2007).

There are some shareholders, however, who rely on their dividends as income. It would not be convenient or practical for them to sell shares in order to receive an income because they would miss out on the opportunity to make capital gains in the future (University of Leicester, 2007). In situations such as these, arbitrage techniques would be necessary to ensure that the needed income is generated by the shareholder himself. For example, an investor could sell sufficient shares to generate the desire income as a substitute for the foregone dividend and buy them back at a later date when his circumstances have improved.

The empirical evidence concerning dividend policy seems to suggest that companies believe the dividend decision is an important one and cannot be treated as a product of investment and financing decisions. Dividend growth tends to lag two to three years behind earnings growth because managers want to be fairly certain that they will be able to maintain the new level of dividends in the future. The fear is that if a company were forced to reduce dividends after an overoptimistic increase in the previous year, the market would read unfavourable information into the dividend decision (Lumby and Jones, 2003).

One option that companies can pursue in an effort to finance internal investment is through the use of external finance, which will affect its capital structure. The use of external finance to fund investment will make the payout of dividends truly irrelevant because the dividends cannot be held to prevent profitable investment into the company.

Raising external finance, either through selling shares or taking out a loan, is likely to change the debt to equity, or gearing ratio, of the company. It is for this reason that the dividend irrelevance hypothesis and the capital structure hypothesis are interdependent. It is this correlation between the two lines of thought that are the core elements behind the Modigliani-Miller theorem.

References

Brealey, R. et al. (2006). Corporate Finance: International Edition, McGraw-Hill: New York, New York

Institute of Chartered Accounts in England and Wales (ICEAW) (2005). Directors Briefing: Overdrafts and Bank Loans, Business Hot Line Publications: London

Lumby, S. and Jones, C. (2003). Corporate Finance: Theory and Practice, Thomson: London, England

Poulson, A. (2006). Corporate Debt
URL: http://www.econlib.org/library/enc/corporatedebt.html
[26 August 2006]

University of Leicester (2007). Module 4 MSc in Finance MN7032D Corporate Finance, Learning Resources: Cheltenham, England

Wikipedia (2007)
URL://http//www.wikipedia.org
[1 March 2006]