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Modigliani and Miller's 1958 paper, "The Cost of Capital, Corporation Finance and the Theory of Investment," is a seminal work in the field of finance that has had a lasting impact on the way that firms make capital budgeting and investment decisions.
In their paper, Modigliani and Miller proposed a theory that has come to be known as the "capital structure irrelevance principle." This principle states that, in a perfect capital market, the value of a firm is not affected by the way it finances its investments, whether through debt or equity. This is because investors can perfectly offset the additional risk of debt financing by demanding a higher expected return on their investment.
Modigliani and Miller's theory challenged the traditional view that a firm's capital structure, or the mix of debt and equity it uses to finance its operations, is an important determinant of its value. Prior to their work, it was widely believed that firms could increase their value by using more debt financing, as this would lead to higher returns for shareholders due to the tax deductibility of interest payments.
However, Modigliani and Miller argued that this view was flawed, as it ignored the impact of financial risk on the value of the firm. They showed that, in a perfect capital market, investors would fully take into account the increased risk of debt financing and adjust their required rate of return accordingly. As a result, the value of the firm would be the same regardless of its capital structure.
Modigliani and Miller's theory has had a major influence on the way that firms make investment decisions. It has led to a greater focus on the overall cost of capital, rather than just the cost of debt, as a key determinant of the feasibility of a given investment. It has also helped to shift the focus of corporate finance away from the traditional goal of maximizing shareholder wealth, to a more holistic approach that considers the interests of all stakeholders, including shareholders, bondholders, and employees.
Overall, Modigliani and Miller's 1958 paper has had a lasting impact on the field of finance, and remains a key reference for practitioners and academics today.
Modigliani and Miller Theory
Therefore, certain modifications had been made to the theory in order to make it practical. Before this time, finance was accepted as a branch of economics. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Capital Structure Signaling Theory Further modification in the Modigliani and Miller theory is made regarding the equal availability of the market information to all investors. The second proxy of financial leverage could be calculated by dividing the total liabilities by the total assets. We find that the capital structure deviates from the optimal level more in firms with stronger managerial power, and these firms have a stronger discount on such deviation.
MODIGLIANI, F.; MILLER, M.H. 1958. The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review , 48 (3):261
They can borrow money by issuing bonds or obtaining loans; they can re-invest their profits in their operations, or they can issue new stock shares to investors. It was published in the form of an article in June 1958 in the American Economic Review. How, for example, is management to ascertain the risk preferences of its stockholders and to compromise among their tastes? From that time, finance was highly approved and accepted by all. In Section II, we show how the theory can be used to answer the cost-of-capital ques- tion and how it permits us to develop a theory of investment of the firm under conditions of uncertainty. NTe now can derive the following two basic propositions with respect to the valuation of securities in companies with different capital structures : Proposition I. The Modigliani and Miller approach is one of the modern approaches of Capital Structure Theory. The profit outcome, in short, has become a random variable and as such its maximization no longer has an operational meaning.
Modigliani and Miller (1958) American Economic Association the Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review, 48, 261
The old capital structure theory is based on a series of strict assumptions, including traditional theory, MM theory and trade-off theory. The dovvnward sloping part of the curve MD perhaps requires some 21 Since new lenders are unlikely to permit this much leverage cf. However, because the cost of capital has become an essentially subjective concept, the utility approach has serious draw- backs for ilormative as well as analytical purposes. What ap- pears to be keeping this line of development from achieving its promise is largely the lack of an adequate theory of the effect of financial struc- ture on market valuations, and of how these effects can be inferred from objective market data. There is neither an advantage nor a disadvantage in using debt in a firm's capital structure. In existing capital markets we find not one, but a whole family of interest rates varying with maturity, with the technical provisions of the loan and, what is most relevant for present purposes, with the financial condition of the borrower Economic theory and market experience both suggest that the yields demanded by lenders tend to increase with the debt-equity ratio of the borrowing firm or individual.
Numerous studies have investigated the relationship between financial leverage and investment decisions by using various approaches in different geographical contexts and at different points in time. Liquidity protection of business, the principle of cash, bill payment, financial report, etc. In 1952, Professor Henry Markowitz developed a portfolio theory named Capital Asset Pricing Model CAPM and called on the based of his name Markowitz Model. However, the same is not the case with dividends paid on equity. We use the term arbitrage advisedly. Then, our Proposition I asserts that we must have in equilibrium: 3 V3-'.
Modigliani, F. and Miller, M.H. (1958) The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review, 3, 261
The MM theory of capital structure suggests that the capital structure of a business is irrelevant to the valuation of the firm. This cluestion has vexed at least three classes of economists: 1 the cor- poration finance specialist concerned with the techniques of financing firms so as to ensure their survival and growth; 2 the managerid econoniist concerned with capital budgeting; and 3 the economic theorist concerned with explaining investment behavior at both the micro and macro 1evels In much of his formal analysis, the economic theorist at least has tended to side-step the essence of this cost-of-capital problein by pro- ceeding as though physical assets-like bonds-could be regarded as yielding known, sure streams. Basic principles of finance, such as those we will learn in this textbook, can be universally applied in business organizations of different types. We have, thus, an analogue to the familiar concept of the industry in which it is the com- modity produced by the firms that is taken as homogeneous. Following are some of the costs incurred in the whole process of bankruptcy of a company. To see why this should be true, suppose an investor is considering buying one of the two firms, U or L. To be sure the price of butter fat will then tend to be higher in relation to that of skimmed milk than in the absence such restrictions the rate of interest will tend to be lower , and this will benefit people who eat at home and who like skim milk who manage their own port- folio and are able and willing to take risk.
Evolution of Finance (8 Stages of Financial Theory Evolution)
For suppose that a large fraction of the population habitually dines in restaurants which are required by law to serve only cream in lieu of milk entrust their savings to institutional investors who can only buy bonds. The American Economic Review, 48, 261-297. For this reason, the loan was arranged in finance, but loan refunds and protection of liquidity became cases of problems. To establish Proposition I we will show that as long as the relations 3 or 4 do not hold between any pair of firms in a class, arbitrage will take place and restore the stated equalities. In particular, the use of debt rather than equity funds to finance a given venture may well in- crease the expected return to the owners, but only at the cost of in- creased dispersion of the outcomes.
The main differences between our view and the current view are summarized graphically in Figures 1 and 2. The theorem was developed by economists Franco Modigliani and Merton Miller in 1958. At the start, the company has 100% equity unleveraged and its value remains unchanged throughout the graph as represented by the straight horizontal lines. For the description of market behavior, however, which is our immediate concern here, the dis- tinction is not essential. The fundamentals of the Modigliani and Miller Approach resemble that of the Net Operating Income Approach.
Jensen have developed the theory based on Markowitz Model. Market imperfections will be dis- cussed in Part D of this section in the course of a comparison of our re- sults with those of received doctrines in the field of finance. For the moment, assume that these corpora- tions can finance their assets by issuing common stock only; the intro- duction of bond issues, or their equivalent, as a source of corporate funds is postponed until the next part of this section. Some of these changes were made by Modigliani and Miller themselves while the rest were applied by other economists. At the macroeconomic level there are ample grounds for doubting that the rate of interest has 2 Or, more accurately, to the marginal cost of borrowed funds since it is customary, at least in advnnced analysis, to draw the supply curve of borrowed funds to the firm as a rising one. Instead, the market value of a firm is solely dependent on the operating profits of the company.
