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"[GE Capital] seemed an easy way to make money...This thing looked like a 'gold mine' to me." A good MBA finance curriculum might kick off with the Modigliani-Miller theorem (M&M), which basically says: 1. Theoretically, you can't create value through your mix of financing. It doesn't matter whether you use 100% equity, 100% debt, or 50/50, your mix of financing won't create value (unlike good R&D for example). 2. #1 above is predicated on the absence of tax incentives, bankruptcy costs, agency costs, and asymmetric information, and the market being efficient. The creators of M&M believed that the assumptions in #2 are mostly false most of the time. The beauty of the theory is in the assumptions themselves. Prescriptively, it basically says that your mix of financing matters only insofar as the assumptions in #2 are false for your project at your company in your country. If you start a division like GE Finance, and you start using complicated financial derivatives, you have several things to prove. You have to show which M&M assumptions are false for your company, to what degree they are false, that your suggested method of financing will take advantage of the M&M violations, and that the magnitude of financing matches the magnitude of M&M assumption violation (this last bit is important, GE really went hog wild with derivatives in a way that was completely not justified). GE Capital never passed the M&M sniff test. |
Modigliani-Miller refers to the financial structure of your corporation, GE in this case: it refers to the mix of capital that GE raises from investors (debt + equity). To give a simple example to illustrate, the value of your lemonade stand as a business is based on your revenue minus your costs, it's based on your "business". You need to raise money to buy your raw materials and equipment to get started or expand? Whether you borrow that money or sell shares in your lemonade stand does not change the value of your business. The bit about absence of tax incentives is because you can write off the interest on debt from the income taxes, but the dividends you pay actually get taxed, so there is an incentive for the equity holders to raise some money via debt rather than equity; but the point that M&M makes remains true.
GE Capital did not fund GE, so M&M doesn't apply.
M&M would apply to GE's ownership of GE Capital, but if all the debt and equity is owned by one entity there really isn't a difference between them (see Humpty Dumpty, back together again).
It's quite common for large industrial companies to have large credit arms: oil companies extend credit to gas stations to buy their gas, just like automobile manufacturers finance car purchases. GE was no different. Leveraging their expertise in finance was a natural extension of the business, and financial firms sometimes fail like any other business, whether they are standalone or wholly owned subsidiaries.