The Modigliani-Miller Theory:Their Importance and Usefulness
To a firm, the most significant everlasting theme is getting the maximum profit with the lowest cost and the least risk. Anybody who studies Corporate Finance knows what an important role the capital structure plays in reducing a firmfs costs and risks. Capital structure is the ratio of equity and debt. A bad financing decision may result in many forms of higher direct or indirect costs, such as lower stock price, higher cost of capital and lost growth opportunities, increased probability of bankruptcy, higher agency cost and possible wealth transfers from one group of investors to another (Sharma, Kamath and Tuluca, 2003, p. 63). Therefore, how a manager finances a firm becomes a key step to a firm. It is also an important part of Corporate Finance and Managerial Finance. The cornerstone theory of the capital structure is the Modigliani-Miller theory (thereafter MM). MM was developed by two economists, Franco Modigliani, a professor at Massachusetts Institute of Technology, and Merton Miller, a professor at University of Chicago Graduate School of Business (Gifford, 1998). By this main contribution, Modigliani won the Nobel Prize in Economics in 1985 and Miller won the Nobel Prize in Economics in 1990 (Wall Stre
MM Proposition III: The type of instrument used to finance an investment is irrelevant to the question of whether or not the investment is worthwhile. (Ross et al., 1995, p647-649) This famous Proposition I was presented in gThe Cost of Capital, Corporation Finance and the Theory of Investmenth, which was issued in the American Economic Review in June 1958. With MMfs help, Modigliani and Miller became laureates of the Nobel Price in Economics. Over a period of almost fifty years, the MM proposition has affected not only corporate finance, but also other fields, such as money and banking, fiscal policy, and international finance. Proposition I has become economic theory (Miller, 1988, p. 307). In corporate finance, people have used this proposition to analyze financial innovation, financial crashes and crises (Stulz, 2000, p. 119). Although it has many restrictive assumptions, it offers a basic theory to examine the real world (Pike and Neale, 1993, p. 354). MM Proposition I has been called ethe third great moment in financial economicsf, and is described as ethe law of conservation of investment valuef (Rubinstein, 2002, p. 1) and estarted a new era in corporate financef (Gifford, 1998).
Some topics in this essay:
Corporate Finance,
Cooper Ijiri,
Pike Neale,
MM Proposition,
Appendix Appendix,
Proposition Ifs,
MM Proposition‡Tis,
Kamath Tuluca,
Price Economics,
Modigliani Miller,
capital structure,
real world,
mm proposition,
value firm,
credit rating,
corporate finance,
cost capital,
perfect capital,
market value firm,
market value,
corporate income,
perfect capital market,
et al 1995,
corporate income tax,
optimal capital structure,
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Approximate Word count = 2016
Approximate Pages = 8 (250 words per page double spaced)
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