Modigliani-Miller theorem
1973. (With R. Shiller.) Inflation, rational expectations
and the term structure of interest rates. Economica 40,
12-43.
1975a. Channels of monetary policy in the Federal
Reserve-MIT-University of Pennsylvania Econometric
Model of the United States. In Modelling the
Economy, ed. G. Renton. London: Heinemann
Educational Books.
1975b. The life-cycle hypothesis of saving twenty years later.
In Contemporary Issues in Economics, ed. M. Parkin and
A. Nobay. Manchester: Manchester University Press.
1975. (With E. Tarantelli.) The consumption function in a
developing economy and the Italian experience.
American Economic Review 65, 825-42.
1977. The monetarist controversy or, Should we forsake
stabilization policies? Presidential address delivered at the
American Economic Association. American Economic
Review 67, 1-19.
1980. (With R. Brumberg.) Utility analysis and aggregate
consumption functions: an attempt at integration. In The
Collected Papers of Franco Modigliani, vol. 2, ed. A. Abel.
Cambridge, MA: MIT Press.
1982. Debt, dividend policy, taxes, inflation, and market
valuation. Presidential address delivered at the American
Finance Association. Journal of Finance 37, 255-73.
1983a. Government deficits, inflation, and future
generations. In Deficits: How Big and How Bad?, ed.
D. Conklin and T. Courchene. Ontario: Ontario
Economic Council.
1983b. Interview with Franco Modigliani. In Conversations
with Economists: New Classical Economists and Their
Opponents Speak Out on the Current Controversy in
Macroeconomics, ed. A. Klamer. Totowa, NJ: Rowman
673
ed. M. Hoskin, J. Flemming and S. Gorini. Oxford: Basil
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1988a. The role of intergenerational transfers and life cycle
saving in the accumulation of wealth. Journal of Economic
Perspectives 2(2), 15-40.
1988b. MM- past, present, future. Journal of Economic
Perspectives 2(4), 149-58.
1997. (With L. Modigliani.) Risk-adjusted performance:
how to measure it and why. Journal of Portfolio
Management 23(2), 45-54.
2000. An interview with Franco Modigliani. Interviewed by
W. Barnett and R. Solow, 5-6 November 1999.
Macroeconomic Dynamics 4, 222-56.
2001. Adventures of an Economist. New York: Texere.
2005. (With T. Jappelli.) The age-saving profile and the
life-cycle hypothesis. In The Collected Papers of Franco
Modigliani, vol. 6, ed. F. Franco. Cambridge, MA: MIT
Press.
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Modigliani-Miller theorem
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The Modigliani-Miller theorem is a cornerstone of
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modern corporate finance. At its heart, the theorem is
1986. (With F. Padoa-Schioppa and N. Rossi.) Aggregate
an
irrelevance proposition: it provides conditions under
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which a firm's financial decisions do not affect its value.
S245-S273, S347-S352.
Modigliani explains the theorem as follows:
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and rational investors, who can 'undo' the corporate
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S. N. Durlauf and L. E. Blume (Eds.), The New Palgrave Dictionary of Economics
© Palgrave Macmillan, a division of Macmillan Publishers Limited 2008
674
Modigliani-Miller theorem
plus equity - depends only on the income stream
generated by its assets. It follows, in particular, that the
value of the firm should not be affected by the share of
debt in its financial structure or by what will be done
with the returns - paid out as dividends or reinvested
(profitably). (Modigliani, 1980, p. xiii)
In fact, what is currently understood as the ModiglianiMiller theorem comprises four distinct results from a
series of papers (1958; 1961; 1963). The first proposition establishes that under certain conditions, a firm's
debt-equity ratio does not affect its market value. The
second proposition establishes that a firm's leverage has
no effect on its weighted average cost of capital (that is,
the cost of equity capital is a linear function of the
debt-equity ratio). The third proposition establishes that
firm market value is independent of its dividend policy.
The fourth proposition establishes that equity-holders
are indifferent about the firm's financial policy.
Miller (1991, p. 5) explains the intuition for the theorem with a simple analogy. 'Think of the firm as a
gigantic tub of whole milk. The farmer can sell the whole
milk as it is. Or he can separate out the cream, and sell it
at a considerably higher price than the whole milk would
bring.' He continues: 'The Modigliani-Miller proposition
says that if there were no costs of separation (and, of
course, no government dairy support programme), the
cream plus the skimmed milk would bring the same price
as the whole milk.' The essence of the argument is that
increasing the amount of debt (cream) lowers the value
of outstanding equity (skimmed milk) - selling off safe
cash flows to debt-holders leaves the firm with more
lower-valued equity, keeping the total value of the firm
unchanged. Put differently, any gain from using more of
what might seem to be cheaper debt is offset by the
higher cost of now riskier equity. Hence, given a fixed
amount of total capital, the allocation of capital between
debt and equity is irrelevant because the weighted average of the two costs of capital to the firm is the same for
all possible combinations of the two.
The theorem makes two fundamental contributions.
In the context of the modern theory of finance, it represents one of the first formal uses of a no arbitrage
argument (though the 'law of one price' is longstanding). More fundamentally, it structured the debate
on why irrelevance fails around the theorem's assumptions: (i) neutral taxes; (ii) no capital market frictions
(that is, no transaction costs, asset trade restrictions
or bankruptcy costs); (iii) symmetric access to credit
markets (that is, firms and investors can borrow or lend
at the same rate); and (iv) firm financial policy reveals no
information. Modigliani and Miller (1958) also assumed
that each firm belonged to a 'risk class', a set of firms with
common earnings across states of the world, but Stiglitz
(1969) showed that this assumption is not essential.
The relevant assumptions are important because they
set conditions for effective arbitrage: When a financial
market is not distorted by taxes, transaction or
bankruptcy costs, imperfect information or any other
friction which limits access to credit, then investors can
costlessly replicate a firm's financial actions. This gives
investors the ability to 'undo' firm decisions, if they so
desire. Attempts to overturn the theorem's controversial
irrelevance result were a fortiori arguments about which
of the assumptions to reject or amend. The systematic
analysis of these assumptions led to an expansion of the
frontiers of economics and finance.
The importance of taxes for the irrelevance of debt
versus equity in the firm's capital structure was considered in Modigliani and Miller's original paper
(1958). Modigliani and Miller (1963) and Miller (1977)
addressed the issue more specifically, showing that under
some conditions, the optimal capital structure can be
complete debt finance due to the preferential treatment
of debt relative to equity in a tax code. For example, in
the United States, interest payments on debt are excluded
from corporate taxes. As a consequence, substituting debt
for equity generates a surplus by reducing firm tax payments to the government. Firms can then pass this surplus on to investors in the form of higher returns. This
raised the further provocative question - were firms that
issued equity leaving stockholder money on the table in
the form of unnecessary corporate income tax payments?
Miller (1977) resolved this problem by showing that a
firm could generate higher after-tax income by increasing
the debt-equity ratio, and this additional income would
result in a higher payout to stockholders and bondholders, but the value of the firm need not increase. The crux
of the argument is that as debt is substituted for equity,
the proportion of firm payouts in the form of interest on
debt rises relative to payouts in the form of dividends and
capital gains on equity. Taxes that are higher on interest
payments than on equity returns reduce or eliminate the
advantage of debt finance to the firm.
The remaining Modigliani-Miller assumptions deal
with various types of capital market frictions (for example, transaction costs or imperfect information) that are
at the heart of arbitrage. The driving force in a perfect
market for a homogeneous good is the 'law of one price'.
If debt and equity are merely different packages of an
underlying homogeneous good - capital - and there are
no market imperfections, then it follows immediately
that the law of one price holds due to arbitrage. Investors
simply engage in arbitrage until any deviation in the
price of the two forms of capital is eliminated. Thus,
the remaining discussion is organized around the
implications of the theorem for firm capital structure,
dividend policy, and the method of capital finance (lease
versus buy).
With regard to firm capital structure, the theorem
opened a literature on the fundamental nature of debt
versus equity. Are debt and equity distinct forms of capital? Why and in what specific ways? In order to answer
these questions about the nature of capital, the optimal