Saturday, February 15, 2014

The Dullest Post I Will Ever Write, I Hope

Here's a post that most--all--readers will regard as one of transcendent obscurity and mind-numbing dullness (if they read far enough to judge).  But I don't have much of any place else to lay it down so it goes here.

The topic is finance, in particular corporate finance, in particular leverage--the ratio of debt to equity on the right-hand side of the balance sheet.  Back when rocks were soft and I studied corporate finance under the great Marvin Chirelstein, we began our inquiry with a case in which the decider undertook to choose the "right" level of leverage (the answer was--I forget).  Anyway, later in the book we learned that there is no "right" level of leverage--the assets don't know who owns them and you can't expand the asset side of the balance sheet by monkeying around* with the liability side.    The jargon name for this insight is "the Modigliani-Miller irrelevance principle," and wouldn't it be cool to be remembered for expanding the realm of irrelevance?

Teaching that stuff now I work out a crude classroom example where the company gets all equity finance at 10 percent, but he could replace equity with debt at only eight percent.  At first blush you say-hey wait a minute, if you pay less for debt, there is more for equity.  Capitalize that equity share at the equity rate and you seem to make equity richer, i.e., to expand the balance sheet.

Can this be right?  No, it is not right.  The point is that equity behind debt is more risky than equity alone, and so demands  higher rate of return.  Once you factor in the risk, the aggregate value of the asset winds up the same.

But here's where I accidentally walked off a cliff.  I was improvident enough to ask myself--well, how do you know the "debt rate?"  Do you just pluck it out of the air or is there some way to derive it from the pure equity play?  First thought: well, senior debt ought to get the same return as pure equity would have gotten because it is facing the same asset value as pure equity. But then it dawned on me: no, senior is not facing the same asset value as pure equity.   Recall that there are no certainties in the world, and the "asset value" is best understood as the probability-weighted sum of all possible outcomes.  Equity gets the full spectrum of possible for values. But debt never gets more than the face amount of the debt.  If the asset value ends up at the top of the spectrum, equity just pays off the debt and keeps the residual for itself.    Or as the option pricing guys would say, buy the stock write a call.

The mind bending inference compelled by this analysis is that "senior debt"is actually less valuable than  pure equity.  Which is exactly the opposite of where I started out.  And, I might add, exactly the opposite of what I have been teaching all these years.

I must be making a rookie error, but what?  

Okay, resume your ordinary lives.  

*Most of my students are Chinese LLM candidates. They are a conscientious bunch, and their English is functional, if not elegant. But what in Sam Hill do they understand when I talk about "monkeying around?"  And who in Sam Hill is Sam  Hill?

1 comment:

bjdubbs said...

There always the risk the equity might do something stupid. And there is no maturity date on the equity.