Merton Miller

From New World Encyclopedia
Revision as of 21:29, 30 September 2007 by Jennifer Tanabe (talk | contribs) (started)



Merton Howard Miller (May 16, 1923 – June 3, 2000) won the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel in 1990, along with Harry Markowitz and William Sharpe.

He was born in Boston, Massachusetts. He worked during World War II as an economist in the division of tax research of the Treasury Department, and received a Ph.D. in economics from Johns Hopkins University, 1952. His first academic appointment after receiving his doctorate was Visiting Assistant Lecturer at the London School of Economics.

In 1958, at Carnegie Institute of Technology (now Carnegie-Mellon University) whose Graduate School of Industrial Administration(now Tepper School of Business) was the first and most influential research-oriented U.S. business schools, he collaborated with his colleague Franco Modigliani there to write a paper on “The Cost of Capital, Corporate Finance and the Theory of Investment.” This paper urged a fundamental objection to the traditional view of corporate finance, according to which a corporation can reduce its cost of capital by finding the right debt-to-equity ratio. According to Miller-Modigliani, on the other hand, there is no right ratio, so corporate managers should seek to minimize tax liability and maximize corporate net wealth, letting the debt ratio chips fall where they will.

The way in which they arrived at this conclusion made use of the "no arbitrage" argument, i.e. the premise that any state of affairs that will allow traders of any market instrument to create a riskless money machine will almost immediately disappear. They set the pattern for many arguments based on that premise in subsequent years.

He was also responsible for the "Irrelevance principle" in which he asserted that the costs of raising capital for a corporation by selling more stock (equity), or issuing more bonds (debt), should be equal; thus a corporation's value in the stock market is independent of its capital structure. His analogy was that a pizza cut up different ways does not change the underlying amount of pizza.

Mr. Miller wrote or co-authored eight books. He became a fellow of the Econometric Society in 1975 and was president of the American Finance Association in 1976. He was on the faculty of the University of Chicago Graduate School of Business from 1961 until his retirement in 1993.

He served as a public director on the Chicago Board of Trade 1983-85 and the Chicago Mercantile Exchange from 1990 until his death in Chicago on June 3rd, 2000.

Modigliani-Miller Theorem

The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed.[1] It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle.

Merton Miller's analogy to illustrate the principle uses a pizza: cutting a pizza into more or less pieces does not change the underlying amount of pizza.[citation needed]

Modigliani won the 1985 Nobel Prize in Economics for this and other contributions.

Miller won the 1990 Nobel Prize in Economics, along with Harry Markowitz and William Sharpe, for their "work in the theory of financial economics," with Miller specifically cited for "fundamental contributions to the theory of corporate finance."


Propositions

The theorem was originally proved under the assumption of no taxes. It is made up of two propositions which can also be extended to a situation with taxes.

Consider two firms which are identical except for their financial structures. The first (Firm U) is unlevered: that is, it is financed by equity only. The other (Firm L) is levered: it is financed partly by equity, and partly by debt. The Modigliani-Miller theorem states that the value of the two firms is the same.

Without taxes

Proposition I: where is the value of an unlevered firm = price of buying a firm composed only of equity, and is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity.

To see why this should be true, suppose an investor is considering buying one of the two firms U or L. Instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the same amount of money B that firm L does. The eventual returns to either of these investments would be the same. Therefore the price of L must be the same as the price of U minus the money borrowed B, which is the value of L's debt.

This discussion also clarifies the role of some of the theorem's assumptions. We have implicitly assumed that the investor's cost of borrowing money is the same as that of the firm, which need not be true in the presence of asymmetric information or in the absence of efficient markets.

Proposition II:

File:MM2.png
Proposition II with risky debt. As leverage (D/E) increases, the WACC stays constant.

  • is the required rate of return on equity, or cost of equity.
  • is the cost of capital for an all equity firm.
  • is the required rate of return on borrowings, or cost of debt.
  • is the debt-to-equity ratio.

This proposition states that the cost of equity is a linear function of the firm's debt to equity ratio. A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt. The formula is derived from the theory of weighted average cost of capital.

These propositions are true assuming the following assumptions:

  • no taxes exist,
  • no transaction costs exist, and
  • individuals and corporations borrow at the same rates.

These results might seem irrelevant (after all, none of the conditions are met in the real world), but the theorem is still taught and studied because it tells us something very important. That is, if capital structure matters, it is precisely because one or more of the assumptions is violated. It tells us where to look for determinants of optimal capital structure and how those factors might affect optimal capital structure.

With taxes

Proposition I:

where

  • is the value of a levered firm.
  • is the value of an unlevered firm.
  • is the tax rate () x the value of debt (D)

This means that there are advantages for firms to be levered, since corporations can deduct interest payments. Therefore leverage lowers tax payments. Dividend payments are non-deductible.

Proposition II:

where

  • is the required rate of return on equity, or cost of equity.
  • is the cost of capital for an all equity firm.
  • is the required rate of return on borrowings, or cost of debt.
  • is the debt-to-equity ratio.
  • is the tax rate.

The same relationship as earlier described stating that the cost of equity rises with leverage, because the risk to equity rises, still holds. The formula however has implications for the difference with the WACC.

The following assumptions are made in the propositions with taxes:

  • corporations are taxed at the rate on earnings after interest,
  • no transaction cost exist, and
  • individuals and corporations borrow at the same rate

Miller and Modigliani published a number of follow-up papers discussing some of these issues.


Footnotes

  1. MIT Sloan Lecture Notes, Finance Theory II, Dirk Jenter, 2003

References
ISBN links support NWE through referral fees

  • Brealy and Myers, Principles of Corporate Finance.
  • G. Bennett Stewart III, The Quest for Value (HarperCollins, 1991).
  • F. Modigliani and M. Miller, "The Cost of Capital, Corporation Finance and the Theory of Investment," American Economic Review (June 1958).
  • M. Miller and F. Modigliani: "Corporate income taxes and the cost of capital: a correction." American Economic Review, 53 (3) (1963), pp. 433-443.
  • J. Miles und J. Ezzell: "The weighted average cost of capital, perfect capital markets and project life: a clarification." Journal of Financial and Quantitative Analysis, 15 (1980), S. 719-730.


Links


Notes


References

Credits

New World Encyclopedia writers and editors rewrote and completed the Wikipedia article in accordance with New World Encyclopedia standards. This article abides by terms of the Creative Commons CC-by-sa 3.0 License (CC-by-sa), which may be used and disseminated with proper attribution. Credit is due under the terms of this license that can reference both the New World Encyclopedia contributors and the selfless volunteer contributors of the Wikimedia Foundation. To cite this article click here for a list of acceptable citing formats.The history of earlier contributions by wikipedians is accessible to researchers here:

The history of this article since it was imported to New World Encyclopedia:

Note: Some restrictions may apply to use of individual images which are separately licensed.