Can Business Firms Have Too Much Leverage? M&M, RJR 1990, and the Crisis of 2008

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.