Friday, 12 June 2009

Modigliani-Miller and West Brom

West Bromwich Building Society has raised £185m of new capital using an innovative new shareholding structure. They were previously a mutual building society but the new move makes the company into a hybrid between mutual and private company.

Does it matter? Economics would say not. The Modigliani-Miller theorem states that (given some assumptions) all forms of capital are equivalent to a company. But in this case, the following questions arise:
  1. There appear to be at least some costs to the firm in raising capital in this new way - at the very least, there will be political and possibly legal costs. The management needs to be able to defend its decision against some of its mutual owners who will object to the fact they now have private shareholders who will share in some of the profits. So why do these costs arise?
  2. Because there are costs, there must therefore be benefits to the new source of capital (otherwise the firm would not pursue it). What are these benefits?
The answer to both questions must be a violation of the Modigliani-Miller theorem. Assuming the proof of the theorem is correct (which is a reasonable assumption as there has been plenty of time to challenge it) some of the conditions must be violated? Which ones, and how? See the wikipedia link above for details of what the conditions are.

Your answers in the comments please.

2 comments:

Anonymous said...

Please delete that "economics says"! It simply doesn't and there are plenty of textbooks that explore the myriad ways in which the MM conditions are not satisfied (e.g., Jean Tirole's "The Theory of Corporate Finance").

Leigh Caldwell said...

Agreed - that's the point of the posting! So which of the conditions are (most) violated in this case?