The Modigliani-Miller Theorem at 60: The Long-Overlooked Legal Applications of Finance’s Foundational Theorem
June 2018 will mark the 60th anniversary of the publication of Franco Modigliani and Merton Miller’s classic article, The Cost of Capital, Corporation Finance, and the Theory of Investment.
Widely hailed as the foundation of modern finance, their article, which purports to demonstrate that a firm’s value is independent of its capital structure, is little known by lawyers, including legal academics. That is unfortunate, because the Modigliani-Miller capital structure irrelevancy proposition (when inverted) provides a simple, but powerful framework that can be extremely useful to legal academics, practicing attorneys, and judges.
Sixty years ago, the field of finance lacked mathematical precision and conceptual rigor, relying heavily on anecdotes and rules of thumb. With their 1958 article, MM, as both the pair of authors and their joint articles are referred to by economists, directly challenged conventional thinking by arguing that under certain idealized assumptions capital structure had no impact on firm value.
Because MM’s proposition was so out-of-step with conventional thinking, it was initially met with deep skepticism. Ultimately, however, after debate, economists concluded that the argument was theoretically correct. Given the initial assumptions (efficient and frictionless markets, no taxes, and only cash flows matter) the result (a firm’s value was independent of its capital structure) held. Nonetheless, most practicing finance professionals ignored MM because their assumptions were so inaccurate as to render the conclusion irrelevant.
Academic economists, however, focused not on the MM result, but on their method of argumentation. MM introduced arbitrage, which is today the cornerstone of finance, into financial economics.
Economists, however, were not finished studying capital structure. And when they returned, they recognized that the MM theorem provided the key: If capital structure affects value, it must operate through the MM assumptions. This reverse MM theorem holds that capital structure can affect firm value only through information, market frictions, taxes, or the allocation of assets with consumption elements.
The reverse MM theorem provides a powerful framework to examine and evaluate capital structure decisions, which can be useful to lawyers as well as financial economists....MORE