"Margin Call", Its Most Definitely Real!!

Inspired by a true story, Margin Call's fictional character 'John Tuld' resembles Merrill Lynches John Thain and Lehman Brother's Dick Fuld in a taut, sinewy drama set in a Wall Street Investment Bank on the night before worldwide financial meltdown. 

After John is informed that his firm is drowning in toxic mortgage backed securities, he demands all the traders under his power to wipe their balance sheet clean and dump all the worthless junk on unsuspecting customers. No, not just any customers, their most valued and loyal ones too. Ruthless! Not like any other movies/documentaries on the crisis I have watched, Margin Call conjured up feelings of disgust, pity and confusion as to why and how one person with all the power is allowed to sit there and potentially cause a global meltdown before they are stopped. It is those emotions indeed that get you thinking: Was this really how Lehman Brothers collapsed? Did the Bank of America save Merrill Lynches in the same way? Did Goldman Sachs and JP Morgan sell these same worthless securities to their clients?. My answer? Yes. 

 A dilemma arises with one of his co-workers, Sam who is unhappy about it all, but is unable to take it further as he risks losing everything if he opposes his boss's ways. Not only does he have to partake in this unethical activity, the entire firm are forced to fire off these securities at rock bottom prices, knowing in a few hours time they will be worthless to everyone! Unethical business at its finest!

  "Your selling something you know has no value!" 

           John - "Be first, be smarter....... or cheat!!" 

More so, analysts should have never let their books to be kept so that if there was a 25% decrease in value of their assets, the loss they would suffer would be greater than the market capitalisation of the whole firm! It is down to Johns ignorance, lack of knowledge and understanding that allowed the firm to cook up and package such toxic mortgage backed securities that ultimately made them crumble. 

The mistake he made was by placing all his eggs in one basket, he ran a huge risk and the company over leveraged itself. In my opinion, he should have invested more so in equity capital, spreading the risk, making failure less and less likely!

So What Is The Best Kind Of Dividend Policy?

As you may already know, the goal of management is to 'create value for stockholders specifically to maximise shareholder wealth' (Jensen, 2001) and one of the factors that plays a role in achieving this goal is dividend policy. Dividend policy is the 'payout policy that a firm follows in determining the size and pattern of distributions to shareholders over time. Firms will distribute cash to shareholders through cash dividends, share repurchases, and specially designated dividends' (Baker & Weigand, 2015). Managers will have the responsibility to devise the best possible dividend policy for both the company and shareholders.

However, early literature on dividend policy expresses different views on the relationship between cash dividends and firm value. Modigliani & Miller (M&M) (1961) suggest that dividends are irrelevant for firm value and possibly even value destroying, whilst Linter (1965) and Gordon (1959) argue that dividends are an extremely important determinant of a firms value.

According to M&M's model, 'the value of a company is determined by its assets and and the cash flows generated by those assets and not by the way firms distribute cash flows to shareholders'(Baker & Weigand, 2015). They argue that in a perfect capital market (no transaction costs, no market imperfections, no taxation), existing shareholders are only fussed about increasing their own wealth, but will be indifferent as to wether it reaches them via dividend or through capital growth. This therefore means that a company can pay any level of dividend, with any financial shortfalls being solved by a new equity issue, being that it is investing in all +NPV projects. If investors needed cash, they could 'manufacture' their own by selling part of their shareholding. As-well as this, shareholders wanting retentions when a dividend is paid can just purchase more shares with the dividend they have received.

Linter (1965) and Gordon (1959) on the other hand argued that dividend policy is relevant to the share value and that investors prefer to receive dividends rather than invest the value of the dividend into future investments that are uncertain. This is known as the "Bird-in-the-hand" theory. Therefore, as investors prefer dividends, if a certain company were to begin paying low dividends investors may sell those shares and instead invest in a company which hayes out higher dividends. This will therefore cause the initial company's share price to fall.

Inevitably it is up to the management to decide wether they want to follow Modigliani & Millers or Linter & Gordons policy, or perhaps any other theories out there. What you must recall though is that in the real world M&M's assumptions stating that perfect capital markets exist, there is no issue cost for securities and that there is no tax, simply can't happen. Otherwise stock market exchange would be useless since we could assume there would not be any tax evasion or fraud in the financial world to establish M&M's assumption.

What is the 'Optimal Capital Structure' companies aim to achieve?

One of the key components of corporate finance nowadays is finding the right mix of debt and equity which is used in order to fund a business. Different companies will have different methods of financing their operations, some may even solely rely on debt or equity whilst others will try find the perfect mix. 'Capital Structure' is defined by Arnold (2013) as the proportion of a company's capital which is debt or equity, but what does this mean?. Capital Structure uses the Weighted Average Cost of Capital (WACC) in order to calculate the average return for a company based on how much debt and equity they hold. This calculation suggests a possible optimal structure. The lower the company's debt and gearing level, the higher the WACC and return for investors. As the gearing level begins to increase, the overall cost of finance decreases , but with it brings the risk of the company becoming financially distressed!

But if debt is a lower cost than equity, it should suggest that companies should just take on more debt rather than equity does it not??? Why is debt generally cheaper than equity? This is down to debt interest being a tax deductible expense which generates tax benefits in most countries, and this is something that dividends are not. The issuing and transaction costs involved with debt are also much lower than that for ordinary shares as-well! On the down side, debt increases the possibility of financial distress due to all its potential costs, which can ultimately lead to bankruptcy!


Back in 1958, two men called Modigliani and Miller devised a theory which argued that companies capital structure has NO impact on the WACC,  NO optimal structure exists and that the companies value depends solely on business risk!! M&M put forward the following 5 assumptions:


1. There is no taxation
2. There are perfect capital markets
3. There are no costs of financial distress and liquidation
4. Firms can be classified into distinct risk classes
5. Individuals can borrow as cheaply as operations






From my current understanding of the topic, I completely disagree with them as you simply cannot ignore taxation when it comes to capital structure!! I think we all know by now as-well that perfect capital markets don't exist in real life and so this was yet another flaw that M&M would come to realise in 5 years time when they had to revise their paper. The 1963 paper proposes that the more in debt a company is the more shareholders will gain although one of the main points to address is that the WACC falls as the gearing rises meaning the company value will increase.


Lehman Brothers is a great example of a company that ended up filing for bankruptcy due to significant debt they racked up, otherwise known as gearing. Its leverage ratio was posing a high risk to the company at 31:1 in 2007. Yes, this may have generated huge profits during the boom, but it left them very vulnerable to extreme risk. I believe that this ratio was very inaccurate and left them susceptible to any downfall. Companies need to ensure they maintain a manageable weighted cost of capital to achieve an optimal capital structure. Both debt and equity obligations should be paid in a timely fashion and that the costs of financing don't ultimately bankrupt the company. My solution is that a firm should choose a range for the optimal; around 20-40% optimal debt ratio in order to maintain financially stable. What do you think? Let me know below!