Modigliani & Miller Simulacrum

The Lives

Franco Modigliani was born in Rome in 1918, emigrated to the United States in 1939 to escape the Fascist racial laws, and held academic positions at the New School, Carnegie Mellon, and MIT. Merton Howard Miller was born in Boston in 1923, trained at Harvard and Johns Hopkins, and spent most of his career at the University of Chicago Graduate School of Business. The two collaborated at Carnegie Mellon in the late 1950s and produced the two papers — *The Cost of Capital, Corporation Finance and the Theory of Investment* (1958) and *Dividend Policy, Growth, and the Valuation of Shares* (1961) — that founded modern corporate finance. Modigliani received the Nobel Prize in Economic Sciences in 1985 (for several contributions, including the life-cycle hypothesis of saving) and died in 2003; Miller received the Nobel in 1990 jointly with Markowitz and Sharpe and died in 2000.

The Thought

The Modigliani–Miller propositions, as they came to be called, established a theoretical baseline for corporate finance that the discipline has worked from ever since. The first proposition states that, under a set of specific simplifying assumptions (no taxes, no bankruptcy costs, no asymmetric information, frictionless markets), the value of a firm is independent of its capital structure — the proportion of debt to equity in its financing does not change its total value. The second proposition states that the cost of equity rises linearly with the debt-to-equity ratio in a way that offsets the cost advantage of debt exactly, so that the weighted average cost of capital remains constant.

These propositions are obviously not descriptions of the real world, in which taxes, bankruptcy costs, and information asymmetries are central features. Modigliani and Miller's contribution was to establish the baseline against which the real-world deviations could be measured. Subsequent corporate finance has consisted largely of the systematic study of how the real world departs from the Modigliani–Miller world, and why — with tax-shield theories of optimal capital structure, agency-cost theories of debt, pecking-order theories, trade-off theories, and so on.

The Legacy

The Modigliani–Miller framework is the starting point of every serious textbook and doctoral programme in corporate finance, and the method it inaugurated — establish the frictionless baseline, then study the deviations — has shaped the discipline more thoroughly than any single substantive result could. The valuation of firms, the analysis of capital structure decisions, the pricing of corporate debt, the understanding of dividend policy, the economics of mergers and acquisitions all rest on the foundation the two papers laid. The Chicago school of corporate finance that Miller led for decades after Modigliani's return to the northeast shaped generations of financial economists and practitioners.