Far from Academic

It was 50 years ago that Franco Modigliani and Merton Miller turned the world of finance upside down. Today, the debate continues over why companies choose the capital structures they do.

Fifty years ago, the American Economic Review published an article that would revolutionize corporate finance. In “The Cost of Capital, Corporation Finance and the Theory of Investment,” future Nobelists Franco Modigliani and Merton H. Miller demonstrated that in an ideal world of perfect markets, no taxes, and no bankruptcy costs, a company’s market value is independent of its capital structure. An optimal debt-equity ratio doesn’t exist. Companies should therefore seek value-creating investments first and worry about the financing later.

What seemed utter heresy at the time is now textbook orthodoxy. Yet debate over Modigliani and Miller’s work (often referred to as “MM,” and including a classic 1961 paper on the irrelevance of dividend policy to firm value) continues today. That’s because in the real world of imperfect markets and taxes, capital structure does matter, thanks in part to the so-called interest tax shield. As Modigliani and Miller acknowledged in 1963, the tax-deductibility of interest payments confers an advantage on debt financing.

MM is notable not only for what it proposed, but because it launched “a 50-year effort to find out what other things would affect financing decisions,” says Stewart C. Myers, the Robert C. Merton (1970) Professor of Financial Economics at MIT’s Sloan School of Management. In a sense, he notes, “researchers have been too successful for their own good.” Currently there are multiple explanations as to why companies choose the capital structures they do, including Myers’s own influential pecking-order theory, “and we can find examples of each one working” in the real world, he says. A unified theory, however, remains elusive.

But there’s more to MM than its propositions. “The [1958] paper broke ground in ways that we now take for granted,” Myers says. For example, it laid out the concept of weighted average cost of capital “in a way that we think about it today.” And the now conventional wisdom that companies should focus on maximizing shareholder value? “Modigliani and Miller weren’t necessarily the first to say it, but when they did, it stuck.”

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