Franco Modigliani (1918-2003)

Content of Presentation
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Earlier life of Guru

Research Interest
Main Research Theory
Books Written
Awards

Franco Modigliani was Italian economist.He was Born in Rome

June 18, 1918. At age 17, he enrolled in the University of Rome to
pursue a law degree.

Modigliani left Italy for Paris to continue studying. In 1939, he

briefly returned to the University of Rome to receive his Doctor
Juris.

1940: Franco Modigliani started hosting informal seminars.

1942: He joined Columbia University as instructor in economics and
statistics

Earlier Life Of Modigliani

1944: Franco Modigliani obtained his D. Soc. Sci. from the New
School for Social Research.

1946: Franco Modigliani became a U.S citizen.

1948: Franco Modigliani awarded the Political Economy Fellowship

of the University of Chicago.

1949: Franco Modiglianis work "Fluctuations in the Saving-Income

Ratio: A Problem in Economic Forecasting, published in Studies in
Income and Wealth.

1954: Franco Modiglianis work with Emile Grumburg, "The

Predictability of Social Events", published in Journal of Political
Economy. This was followed by publication of another work with
Richard Brumberg - "Utility Analysis and the Consumption
Function". This was published in Post-Keynesian Economics.

1958: Franco Modiglianis work with Merton Miller "The Cost of

Capital, Corporation Finance, and the Theory of Investment" was
published in American Economic Review.

1963: Franco Modiglianis work with Merton Miller "Corporate

Income Taxes and the Cost of Capital" was published in American
Economic Review.

Franco Modigliani died on September 25, 2003, at the age of 85

Reaseacher Main Interest

Field of Reasearcher is Financial economics.

Financial economics is the branch of economics studying the

interrelation of financial variables, such as prices, interest rates and
shares, as opposed to those concerning the real economy.

Financial economics are typically framed in terms of "time,

uncertainty, options, and information.

The
The Collected
Collected Papers
Papers o
o
ff Franco
Modigliani
Franco Modigliani

The
The Collected
Collected Papers
Papers of
of
Volume
Volume 5:
5: Savings,
Savings, Def
Def
icits,
icits, Inflation,
Inflation, and
and F
F
inancial
Theory
inancial Theory
published
published 1989
1989

published
published 2005
2005

The
The Debate
Debate Over
Over Stabili
Stabili
zation
zation Policy
Policy
published
published 1986
1986

The
The Collected
Collected Papers
Papers of
of
Monetary
Monetary Theory
Theory and
and St
St
abilization
abilization Policies
Policies
published
published 1989
1989 ,,

The
The European
European Ec
Ec
onomic
onomic Recovery
Recovery
:: A
A Need
Need for
for Ne
Ne
w
Policies?
w Policies?

The
The Collected
Collected Papers
Papers
of
of Franco
Franco Modigliani,
Modigliani,
Volume
Volume 1:
1: Essays
Essays in
in
Macroeconomics
Macroeconomics
published
published 1980
1980

The
Of
An
The Collected
Collected Papers
Papers o
o Adventures
Adventures
OfPension
An Economi
Economi
Rethinking
Rethinking
Pension
ff Volume
3:
The
Theory
Volume 3: The Theory st
st Reform
Reform
of
of Finance
Finance and
and Other
Other
published
published 2004
2004
Essays
Essays

Books Written By Modgilaini

Capital Markets: Inst

itutions And Instrume
nts
published 1992

The Monetarist Contr

oversy: A Seminar Di
scussion

Foundations of Financ
ial Markets and Insti
tutions
published 1901

Mortgage and Mortga

ge-Backed Securitie
s Markets
published 1992

Investment
Management
Published 1995

Books Written With Co-Authur

Sostenibilita E Solvibilita
del Debito Pubblico
in Italia: Il Conto Dei
Flussi E Degli
Stock Della Pubblica
Amministrazione a Livello
Nazionale E Regi

Avventure Di Un
Economista
: La Mia Vita, Le Mie Idee
, La Nostra Epoca

Guida AI Lugosi Etruschi

Books Written In Italian

ModiglianiMiller theorem
The theorem was first proposed by F. Modigliani and M. Miller in 1958.

Franco Modigliani, Merton Miller forms the basis for modern thinking on
capital structure. The basic theorem states that, under a certain market
price process (the classical random walk), in the absence of taxes,
bankruptcy costs, agency 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
ModiglianiMiller theorem is also often called the capital structure
irrelevance principle.

Main Research Theories

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
ModiglianiMiller theorem states that the value of the two firms is the same.

Without taxes
VU=VL where VU is the value of an unlevered firm = price of buying a
firm composed only of equity, and VL is the value of a levered firm = price
of buying a firm that is composed of some mix of debt and equity.

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.

With taxes

VL = VU +TcD
VL is the value of a levered firm.
VU is the value of an unlevered firm.
TcD is the tax rate (Tc ) x the value of debt (D) debt is perpetual .

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.
Following assumptions are made in the propositions with taxes:
corporations are taxed at the rate on earnings after interest.
no transaction costs exist.
individuals and corporations borrow at the same rate.

Proposition II : with risky debt. As leverage (D/E) increases, the WACC

(k0) stays constant

Ke = is the required rate of return on equity, or cost of equity.

K0 = is the company unlevered cost of capital (ie assume no leverage).
Kd = is the required rate of return on borrowings, or cost of debt.
D/E = is the 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 (WACC).

These propositions are true assuming the following

assumptions:
no transaction costs exist, and
individuals and corporations borrow at the same rates.

Important implications for the theory of

One is that such decisions can be separated from the

corresponding of financial decision.

Another implication is that the rational criterion for investment

decisions is a maximization of the market value of the firm.

Third is that the rational concept of capital cost refer to total cost,
and should be measured as the rate of return on capital invested in
shares of firms in the same risk class.

In the early 1950s, Franco Modigliani and his student, Richard Brumberg,
developed a theory based on the observation that people make
consumption decisions based on the resources available to them over their
lifetime.. They had observed that individuals build up assets at the initial
stages of their working lives. Later on during retirement, they make use of
their stock of assets. The working people save up for their post-retirement
lives and alter their consumption patterns according to their needs at
different stages of their lives.

The Life Cycle Hypothesis (LCH) is an economic concept analysing

individual consumption patterns. The life-cycle hypothesis considers that
individuals plan their consumption and savings behaviour over the long
term and intend to even out their consumption in the best possible manner
over their entire lifetimes.

The Life Cycle Hypothesis

Assume that there is a consumer who expects that he will live for
another T years and has wealth of W. The consumer also expects
to earn income Y until he retires R years from now.

The consumer can distribute his lifetime resources over the

remaining T years of his life. He divides W + RY equally among T
years and in each year he consumes.

It has to be added that we are assuming that the interest rate is

zero. If the interest rate were positive, we would have to account for
the interest earned on savings.

if the income falls to zero the amount of consumption will be equal

to aW. However, this is not a fixed value, as it depends on wealth

The consumption function of this person can be written as

If every individual in the economy plans his consumption in this manner, then
the aggregate consumption function will be quite similar to the individual one.
Thus, the aggregate consumption function of the economy is

where a is the marginal propensity to consume out of wealth and b is the

marginal propensity to consume out of income.

Implications
Moreover, according to the given consumption function, the
average propensity to consume is

Wealth does not change proportionately with income from

individual to individual.

We

should get the result that high income leads to a low

average propensity to consume.
However,

generally over a long period of time, wealth and

income increase together which leads to a constant ratio WY
and thus a constant average propensity to consume.

It was observed average duration of working life and retired life and the
rate of earning is constant till retirement and so is the rate of
consumption combined with a zero rate of return on net worth we can
find that in a stationary economy of constant population and
productivity, the aggregate stock of wealth would be very significant.

Moreover, under the given conditions, the aggregate rate of

saving would become zero as the level of positive saving by
the individuals during their earning years would be offset by
the dissaving of the retired households using up their earlier
accumulation.

Saving and Wealth when Income and

Population are stable

If the size of the cohorts born in successive years grows at the rate
p then both population and the aggregate income will grow at the
rate p. As a result of this growth there will be an increase in the ratio
of younger individuals in their earning phase to retired individuals in
their dissaving phase, leading to a positive net flow of saving.

It can also be seen that if the rate of growth of population is

constant in time then aggregate saving and wealth will also
increase at the rate p and hence will be proportional to aggregate
income.

The Effect of Population Growth

We now consider the situation where population is stationary but

average income earned at each age, and hence, aggregate income
rises continuously over time due to increasing productivity. This will
also have a tendency to lead to a positive rate of saving and a
growing stock of wealth.

Moreover this implies that the currently working generation will aim
for a level of consumption in their post-retirement years larger than
the consumption enjoyed by the currently retired individuals
belonging to a less affluent generation.

The Effect of Productivity Growth

The findings of many economists bring out a problem in the lifecycle model. It was found out that the elderly do not dissave .
There are two explanations for the aforementioned behaviour of the
elderly.
The first explanation is that the retired individuals are cautious about
unpredictable expenses. The additional saving that arises due to
this behaviour is called precautionary saving. Precautionary saving
may be made for the probable event of living longer than expected
and hence having to provide for a longer than the planned span of
retirement. Another rational reason is possibility of ill-health and
huge medical expenses.
The second explanation is that the elderly may save more
in order to leave bequests to their children. This will
discourage dissaving at the expected rate.

Theory and Evidence

Contribution of Modigliani
Developed sub models of private consumption and the financial sector,
studied the consequences for household saving of changes in
demography and economic growth, and laid the foundation for the
field "corporate finance.

Nobel Memorial Prize in Economics, 1985

MIT's James R. Killian Faculty

Achievement Award, 1985.

Achievements and Awards

Died
Franco

Modigliani died on September 25, 2003,

at the age of 85

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MBA3.5(5th)

3/18/15