Merton Miller

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Merton Howard Miller (May 16, 1923 – June 3, 2000) was an American economist, who co-authored famous Miller-Modigliani theorem that deals with relationship between a company's capital-asset structure and its market value. He won the Nobel Prize in Economics in 1990, along with Harry Markowitz and William Sharpe, for his pioneering work in the field of corporate finance theory.

Life

Merton Howard Miller was born in Boston, Massachusetts, the only child of Joel and Sylvia Miller. He followed his father’s steps, who was a Harvard graduate, and entered Harvard University in 1940, earning his bachelor's degree in 1944. One of his colleagues at the university was Robert M. Solow, the laureate in Economics for 1987.

During the World War II, Miller worked for several years as an economist in the division of tax research of the United States Treasury Department, and in the Division of Research and Statistics of the Board of Governors of the Federal Reserve System.

In 1949, Miller started his graduate studies, receiving a Ph.D. in economics from Johns Hopkins University in 1952. His first academic appointment after receiving the degree was Visiting Assistant Lecturer at the London School of Economics. In 1953 he started to work as professor at Carnegie Institute of Technology (now Carnegie-Mellon University), in Pittsburg, Pennsylvania, where he stayed until 1961. At the time, Institute’s Graduate School of Industrial Administration (now Tepper School of Business) was among the first and most influential research-oriented U.S. business schools. His colleagues at the University were Herbert Simon (Economics Laureate 1978) and Franco Modigliani (Economics Laureate 1985).

In 1958, Miller collaborated with Modigliani to write a paper on The Cost of Capital, Corporate Finance and the Theory of Investment, first in the series of papers on corporation finance. Miller wrote or co-authored eight books in total, including Merton Miller on Derivatives (1997), Financial Innovations and Market Volatility (1991) and Macroeconomics: A Neoclassical Introduction (1974, with Charles Upton).

In 1961, Miller accepted appointment on the faculty of Graduate School of Business at the University of Chicago, where he stayed until his retirement in 1993. He served during 1966-1967 as visiting professor at the University of Louvain in Belgium. In Chicago he continued to work in the area of corporate finance.

In 1969 Miller’s first wife Eleanor died, living him with his three daughters. His second wife's name was Katherine.

Miller became a fellow of the Econometric Society in 1975 and was president of the American Finance Association in 1976. He served as a public director on the Chicago Board of Trade 1983-85 and a director of the Chicago Mercantile Exchange from 1990 until his death. He continued to teach after his retirement in 1993.

Miller died in Chicago on June 3rd, 2000.

Work

Miller started his work on corporate finances with his 1958 paper, The Cost of Capital, Corporate Finance and the Theory of Investment, which he co-published with his colleague Franco Modigliani. The 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, on the other hand, there was 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 Miller and Modigliani arrived at their 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.

Modigliani-Miller theorem

The Modigliani-Miller theorem 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. 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. 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.

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.

Legacy

Morton Miller was one of the most important researchers in the area of corporate finance. He revolutionized the field, constructing sophisticated theories from numerous separate rules and theories that existed before. Together with his fellow Nobel laureate Franco Modigliani, he developed famous Miller-Modigliani theorem on capital structure and dividend policy that set up the foundation of the theory of corporate finance. In 1990, Miller was awarded the Nobel Prize in Economic Sciences for his work on the theory of financial economics. He influenced numerous economists who followed in his steps.

Publications

  • Fama, Eugene F., and Merton H. Miller. 1972. The theory of finance. New York: Holt, Rinehart and Winston. ISBN 0030867320
  • Miller, Merton H. 1986. The academic field of finance some observations on its history and prospects. Chicago, Il: University of Chicago
  • Miller, Merton H. 1991. Financial Innovations and Market Volatility. Cambridge, MA: Blackwell. ISBN 1557862524
  • Miller, Merton H. 1997. Merton Miller on Derivatives. New York: Wiley. ISBN 0471183407
  • Miller, Merton H. 1998. The M&M Propositions 40 Years Later. European Financial Management, 4(2), 113.
  • Miller, Merton H. 2005. Leverage. Journal of Applied Corporate Finance. 17(1), 106-111.
  • Miller, Merton H. and Modigliani, F. 1958. The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review, 48(3), 261-297
  • Miller, Merton H. and Modigliani, F. 1963. Corporate income taxes and the cost of capital: a correction. American Economic Review, 53(3), 433-443.
  • Miller, Merton H., and Scholes, Myron S. 1982. Dividends and taxes some empirical evidence. Chicago: Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  • Miller, Merton H., and Upton, Charles W. 1974. Macroeconomics: A neoclassical introduction. Irwin series in economics. Homewood, Ill: R.D. Irwin. ISBN 0256015503

References
ISBN links support NWE through referral fees

  • Brealy, Richard A. and Myers, Stewart C. 1984. Principles of Corporate Finance. New York: McGraw-Hill. ISBN 007007383X
  • Miles, J. and Ezzell, J. 1980. The weighted average cost of capital, perfect capital markets and project life: A clarification. Journal of Financial and Quantitative Analysis, 15, 719-730.
  • Stern, Joel M., and Chew, Donald H. 2003. The revolution in corporate finance. Malden, MA: Blackwell Pub. ISBN 1405107812
  • Stewart, G. Bennett. 1991. The Quest for Value. New York: HarperCollins. ISBN 0887304184

External links

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