Betting the Business

Students of corporate finance are familiar with the Modigliani-Miller irrelevance propositions. Proposition 1 says that the value of a firm is determined by the firm’s cash flow from assets and is independent from its capital structure. The Proposition is often presented to demonstrate the irrelevance of choosing between debt and equity, but the underlying logic is more general than that. The Proposition applies to any choice in the set of contracts used to finance the firm. These include hedges, for hedges are implemented with financial contracts that change the balance sheet of the firm. So, what we call the M-M Proposition of Hedging is simply a corollary to the original M-M Proposition 1.

The M-M Proposition of Hedging states that the value of a firm is independent of whether or not it hedges. Again, the argument is: the cash flow stream generated by the firm’s assets determines a firm’s value. If the firm lowers the risk of its cash flow stream by selling a risky cash flow in the capital market in exchange for a low risk cash flow—i.e., by hedging—the value of the firm remains unchanged. The value of the unhedged, high-risk cash flow is equal to the value of the hedged, low-risk cash flow. While this may seem counterintuitive at first, a moment’s reflection resolves the problem. When selling the high risk cash flow to the capital market, the firm is, of course, forced to also surrender a correspondingly high return. It receives in exchange a low risk, but also low return cash flow. In the capital market, the value of the two cash flows are the same.

Many assumptions are required for the M-M Propositions to work. One key assumption underlying the M-M Proposition of Hedging is that the cash flows from any financial security being sold by a firm are all valued in the same frictionless capital market. While a firm can package its cash flows into securities with different amounts of risk, including equity, debt and hedges, investors in the capital market can repackage these securities into new securities with new amounts of risk determined by the investors. Of course, we assume that when a firm packages its cash flows into securities and these securities are then repackaged by investors, the total cash flow is conserved. Nothing is lost or gained in the process. This is what is meant by frictionless, a variation of the Lavoisier law of conservation of mass. Applied in this case, frictionless implies that the choices made by a firm do not affect the final opportunities available to investors, so the total value of cash flows is unaffected by how the firm chooses to package them.

It is easy to dismiss the M-M Propositions as unrealistic. The world is just too imperfect: Transaction and bankruptcy costs; entropies from conflicting interests among equity holders, managers, equity holders and creditors; information gaps between firms’ insiders and the capital markets; and so on render the M-M irrelevance propositions irrelevant.

But there is more to the M-M Proposition than meets the eye. At a deeper level, the key is not to accept the result at face value, but to understand the relationship between the assumptions and results.

The Proposition points out the need for corporations that engage in hedging to target the real source of value from hedging. Modern capital markets are quite sophisticated and much less frictionless than fifty years ago when the M-M Propositions were written. For many companies, the opportunity to impact total firm value directly through hedging or related financial strategies is an illusory, if not futile and costly activity that only serves to enrich investment banks and distract managers. Prior to modern management gurus, Modigliani and Miller realized that true value comes from focusing on managing the firm’s assets well and making sound investment decisions.

Hedging can only increase value if it somehow impacts on the firm’s ability to manage its assets well or execute on its investment strategy. This is an indirect source of value, and one that is difficult to analyze.