Irrelevance Proposition Theorem
Categories: Financial Theory
The irrelevance proposition theorem theorizes that financial leverage...i.e. debt, loans...does not affect the value of a company...as long as there are no distress costs (which means they’d be having trouble making payments) nor income tax (another cost) on the business.
The irrelevance proposition theorem is the main premise of “The Cost of Capital, Corporation, Finance, and Theory of Investment," a journal article that won a Nobel Prize. Or rather, the authors did. The two dudes who came up with this, Miller and Modigliani, argued that, in an efficient market with no added fees (and assuming they’re not on the verge of bankruptcy), the value of a company shouldn’t depend on how it’s being financed, since investors can buy in or sell out at any time.
Of course, in the real world, there are income taxes on businesses...but hey, the real world is always messier than our theorems about how the world works. Rather than being a theorem based on how businesses work, it’s more of a window into financing options for businesses.
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Finance: What is operating leverage?729 Views
Finance a la shmoop. What is operating leverage? It's good leverage not like
debt which is a liability and quote bad leverage unquote. Good leverage means a [Operating leverage vs debt diagram]
few things like when you scale in operations and grow very very large then
you have leverage over your suppliers. It's a very different discussion when [Tomatoes in water]
you're buying Tomatoes for your spaghetti sauce like when you're buying
ten thousand tomatoes a month versus when you get very very big like Egyptian [Pyramid of tomato baskets]
pyramid big and are buying 10 million Tomatoes a month like that scale, you get
way more attention at that point from the non-union labor picking them in [Two guys pop out a bush]
Mexico and can command a whole lot more in discounting as far as deal terms go
and you know other favors when you negotiate well operating leverage works [A trolley being pushed around a supermarket]
with stocking grocery shelves as well, meaning that if you are coca-cola you
have a whole lot more operating leverage with Safeway than does Salmonelli's [Scales of the businesses and Safeway showing Coca-Cola with more leverage]
pesto in a can like nobody goes into a Safeway or Kroger's hunting for a brand
of pesto sauce but pretty much every soda drinker on earth which is pretty [Lots of people on a map of the world]
much every human on earth buys Coke or Pepsi and both have extreme operating
leverage. While operating leverage comes in a range of forms like for example
let's consider a semiconductor maker this isn't fizzy water and sugar and [Someone opens a soda can and it explodes everywhere]
union Teamster co-opting this is actually really hard Tech where it took
decades to be able to produce gigaflops of information put through a tiny piece [Binary code going by]
of fiber for a dollar, really hard to make highly unlikely that Somalia is
gonna one day be a big competitor in the semiconductor architecture business so [Guy plugs something in and it explodes]
the winner in that space a little company called
Intel. Yeah it had for a long time a virtual monopoly in being able to [Monopoly logo appears]
produce massive computing power for an incredibly cheap or high value price. [High value price tag appears]
Well Intel had massive operating leverage in its heyday until Apple and a
few Chinese companies spent a hundred billion dollars or so making themselves [Apple and Intel in a boxing ring]
into viable competitors and yeah and that's [Apple chucks a fire ring at Intel and knocks it out the ring]
what happens when you try to be a monopoly in a competitive world.
Well the key idea here is that operating leverage or power that a business has in [Definition of operating leverage]
running itself usually translates directly in the form of profit margins
like the more operating leverage accorded a company the higher its profit [Operational leverage is piled onto the scale and profit margins take off]
margins will usually run which is very different from this kind of operating [A surgeon wiggling a tool round in an operation]
leverage...