Non Financial Liabilities

Versions of M&M still In Table 16.1, IBM's total liabilities were about three times as large as financial debt. Such ^onside^fher a ratio is typical for most U.S. companies. Does the M&M proposition that firm value is not liabilities. influenced by capital structure still apply if other liabilities are present? It does, but there are some subtleties.

• If you wish, you can continue think of financial claims, such as debt and equity, as their own universe. In this case, the M&M proposition can be interpreted to apply only to these financial claims. It then says that the value of the firm's financial claims is the value only of the firm's assets which are not impaired by the other liabilities. It is independent of the mix between financial debt and financial equity.

• You can also think up a novel version of the M&M proposition that encompasses other liabilities and thus applies to the entire firm. This M&M version would have to assume that an arbitrageur can buy and issue all claims (financial and non-financial) to which the revised proposition should apply. If any suboptimal arrangements, be they capital structure or operations related, can be instantly corrected by competitive arbitrageurs, M&M stands. It would follow, then, that the firm's value would be independent of the arrangement of claims, because these would be freely and instantly rearranged into an optimal constellation by outside market pressures.

Yet, it may be too early to declare victory. Although it is natural to think of the purchasing of debt and equity in financial markets to work relatively perfectly and efficiently, this may not be the case here. Remember that arbitrageurs now have to purchase and sell claims that arise through the firm's operation in real markets. They would need the power to instantly reorganize the firm to take advantage of any mistakes. Judge for yourself whether you think arbitrageurs can instantly correct the following:

1. If vendors (accounts payables) or the IRS (taxes payable) grant the equivalent of low-interest rate loans to the firm, the firm should assume more of them. If a different capital structure can increase these loans, the right constellation can optimize firm value.

2. If other vendors provide better terms on the accounts payables, given identical service otherwise, these are the vendors that the firm should take. The right constellation can optimize firm value.

3. If the firm has made the mistake of selecting a structure that had it place its headquarter into a country with high taxes, the M&M argument to unwind this inferior choice would be for the financial markets to purchase the firm, relocate the headquarters, and therefore reduce the taxes. The right constellation can optimize firm value.

If arbitrageurs cannot take over the firm to undo mistakes and then resell it optimally packaged, then the value of the firm can indeed depend on the current capital structure and M&M may not hold. In sum, relying on the perfect market assumption seems less realistic on Main Street than on Wall Street. Fortunately, the point of the M&M proposition, however, was never to be realistic. Instead, it was to force you to think about what matters. If the loss due to the choice of vendors not offering the most competitive arrangement (accounts payables) were too large, a takeover by arbitrageurs would become profitable. Thus, the cost of arbitrage is an upper bound to the cost of what inefficient operations can create.

Careful with WACC, There is one more subtle issue that arises with the numbers that go into the WACC formula.

though. Above, you learned that you can obtain the costs of capital of financial claims—or for that matter any perfectly competitively obtained claims—through the CAPM. Unfortunately, this is not necessarily the case for claims that do not arise in competitive markets (e.g., for tax liabilities). This can mean that entrepreneurs may not be able to correct mistakes, in which case the WACC may not be independent of the firm's capital structure, after all. This will soon become clear.

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