The theory presented here by the work of Modigliani and Miller has been one of the defining works of modern finance and can be said to be the foundation of much of the subsequent work that has been done in the field. The whole study can be looked at from the perspective of the existing literature presented by economic theorists in the 1950s. These theories were ripe with detrimental simplifications such as regarding the fixed income securities such as bonds as being able to provide a sure source of steady income. The cost of capital is thus generally held to be the interest rate on bonds meaning that the firm will invest until the marginal yield gets up to the level of the marginal interest.
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Two main concerns
Managerial decision-making was guided by two main concerns, the maximization of profits and of the market value of the firm which benefited the shareholders of the firm. This had led to a utility maximization attitude of managers under certain conditions which made the decision-making process increasingly subjective. The alternate option that was identified to this was market value maximization. In this regard, however, there were questions because of the lack of a capital structure theory and knowledge of the impact of structural variability. Thus finance experts were faced with three primary concerns that hinged around the possible impact of capital structure in determining a firm’s market value, the cost of capital, and whether the divergent forms of securities available make an individual impact.
Modigliani and Miller’s propositions
Modigliani and Miller came up with their propositions that sought to answer these important questions that can be said to be at the heart of investment theory. They first identified that the market value of a firm is not dependent on the capital structure adopted. Thus whether capital is gained through issuing equity or debt, its market value will not show much volatility because of either. Secondly, they concluded that the cost of equity of a firm is a linear function of the debt to equity ratio of the company in question. This shows a direct proportion link between debt and ROE. Once these baseline concerns were identified through the theory laid down by the two researchers, it drew extensions with variations involving the corporate tax on companies which reduced the interest payments involved for the company through a tax shield. There were also others involving arbitrage-linked market imperfections.
The authors took the theory and tested it through the use of data from an oil company and electricity utility companies in 1954-1955. The conclusions from this seemed to appear in favor of the propositions put forth by Modigliani and Miller which verifies their results to a great extent. Once these two propositions were shown to stand, it led to the third proposition by extension which answered the third important concern of financial experts. It showed that the type of security used among the many available has little or no effect on the cut-off point for investment that a firm decides. This implies changing the way financial experts and economists appraise alternative investments.
However, in terms of the debt financing perspective, Modigliani and Miller provide an idea that “debt-financing should be “cheaper” than equity-financing” (18). Looking back at the time when such research was done it is necessary to point out that in the contemporary world of finances such manipulations in the market provoked debt crisis. Laudon and Laudon (2009) provide an idea of how the mortgage crisis became one of the major reasons for the world economic crisis. On the example of HSBC’s financial structure, being the third hugest bank in the world, the mortgage operations were gone too far when the financial mass decreased when demands of customers increased. As a result, the bank lost its attractiveness credibility. Moreover, it caused the wave of mortgage speculations disclosure.
Giving an example by David Durand, when pointing out that insurance companies are restricted to provide any services in terms of debt securities and can serve nonfinancial companies, the significance of the interest rates becomes more apparent. By this, it is needful to admit that in the short-term and long-term perspective the interest rates for any sort of loans can be reduced in terms of modern financial development by making several payments at various intervals depending on the current situation with market fluctuations. In this respect in today’s reality, the picture of a perfect market assumes the need to promote proposals without any separation of them into peculiar parts.
If the paper presented by the two authors is evaluated, it can be seen to have sound arguments that have a persuasive element to them. This is achieved through a combination of theoretical development, empirical evaluation, and making good use of examples. The evidence was also substantial enough to raise concerns regarding the points presented about the change required in the way capital structure theory has been looked at. The work did however come under scrutiny and attracted some criticism for some of the factors it was seen to overlook. The first among these was a questioning of the simplifying assumptions that Modigliani and Miller made such as the absence of corporate taxes, the lack of consideration for paying investment bankers certain amounts for raising capital. This was accompanied by others such as the lack of legal fees for bankruptcy which negated these potential costs. These assumptions while standard practice in the economic model making can not be seen to hold in real-life finance which brings into question their ability to alter the framework in which modern finance operates. In this respect, the significance of decentering of global firms plays a great role. In other words, a global company of the present day should have an idea of where to fix its financial home, legal home, and home for managerial talent (Desai, 2008). For convenient and lower state policy as of taxation, a rationale leads to those countries where tax rates are the lowest in the world. For cheaper labor, global companies concentrate on the other type of home in countries where it is possible to find cheap labor power. For making more deals it is vital to place financial home in the juncture of financial torrents. The other major criticism can be seen from the viewpoint of taxes. This was made through the underestimation made by the authors of the benefits of tax shields. This was supplemented by the concern surrounding information asymmetry in the real world which has a direct impact on some equity issues being successful and others not. It also means that companies face different costs in this regard. Despite these criticisms, however, Modigliani and Miller were able to raise important questions in the world of finance that still form the hallmark of the study being conducted in academic circles of this subject today.
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- Modigliani, F & Miller, M 1958, “The Cost of Capital, Corporation Finance and the Theory of Investment”, The American Economic Review , 48 (3), June, pp. 261-297.
- Laudon, KC, and Laudon JP 2009, Management Information Systems: Managing the Digital Firm, Ed. 11, Pearson Prentice-Hall, Upper Saddle River, New Jersey.
- Desai, MA 2008, The Decentering of the Global Firm. Harvard University and NBER, Cambridge, MA.