Many moons ago at the University of Chicago Booth School of Business, my professors shared a mind-numbing amount of financial theories, and one or two are still inside my brain today.
The work by Modigliani and Miller – fondly referred to as M&M – guides business leaders’ risk decisions, even today. Early on in the 1950s, as professors at Carnegie Mellon University, the Modigliani and Miller team researched and published a paper indicating that a higher debt-to-equity ratio leads to a higher return on equity. In other words, the more debt used to finance a company’s operations, the more likely the company will outperform its competitors.
For example, Company A, with $10 million book value, borrows $4 million resulting in a debt-to-equity ratio of 40 percent. That company will outperform Company B, which borrows at a 20 percent debt-to-equity ratio.
Franco Modigliani received the 1985 Nobel Prize in Economics for this theory as well as his other research. Merton Miller, a past professor at the Booth School, received a Nobel Prize in 1990 for his “fundamental contribution to the theory of corporate finance.”
Good debt: The M&M theorem, much like those chocolate treats we love today, keep us in a good place. Business leaders struggle with decisions of company growth and how to finance that growth. More often than not, they make a choice of raising money through issuing shares and/or through borrowing, just as implied by the theorem. The benefits and risks to both of these financing options belong in another article. However, the key to determining the best option should be based on cash flow. Said another way, debt is good as long as you can cover the debt payments.
We have a good example here in McHenry County. All-Rite Spring Company in Spring Grove, run by President John Bilik, has been in the midst of a major expansion. Bilik sharing this assessment, said, “The company is strong in part because we focus on building the business around the lowest process costs and seek work with high enough volume to justify the expense of building the appropriate process. We continue to invest in training, plant and equipment.” The investment included a trip to the bank to borrow money. While John‘s wife, Lisa, said, “it’s a bit scary,” this family business has evaluated future cash flow risks and proceeded to increase debt to fund future growth.
Bad debt: Modigliani and Miller’s theory plays a role in how many individuals think about and use their money – although not always with good results. Americans love their homes and traditionally borrow money to finance these purchases. Banks, the traditional source of lending, evaluate borrowers on their debt-to-equity ratio.
Before the 2008-09 Great Recession, the rules were ignored: large personal debt relative to assets didn’t stop people from borrowing, nor banks from lending.
Then job loss led to cash flow shortages that led to arrested mortgage payments that led to foreclosures. While lenders and borrowers historically repeat their mistakes, we can hope this last lesson sticks around for a while.
As a financial adviser, families hire me to help them regroup. They bought the monster house in the fancy neighborhood, which turned out to be a drag on net worth – or to say it another way – a negative investment return. Their credit cards with rates as high as Willis Tower are sapping what little income is left over after paying the necessitates. The work takes time and sacrifice to pare bad debt, to budget and to prioritize.
“Debt” isn’t a dirty word, it’s just misunderstood and misused. Companies and individuals with healthy respect for the use and misuse of debt can harvest the power of borrowing for future growth. Let’s keep Modigliani and Miller in our thoughts as we evaluate our financial futures and make smart choices.
• Amy Barrett, CFA, CFP, CDFA, is a financial adviser and the founder of Barrett Wealth Connection, 7919 Schmidt St., Spring Grove. Reach her at 815-529-7527, firstname.lastname@example.org or via www.bwconnect.co.