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Famous as Born on Born in Nationality Field Works & Achievements Influenced Eugene Fama Michael Jensen Richard Roll Myron Scholes Economist 16 May 1923 Boston, Massachusetts United States Economics Modigliani-Miller Theorem, Nobel Prize Recipient
03 June 2000
1- DETAILED INTRODUCTION
Born in Boston, Massachusetts on May 16, 1923, Merton Miller was born to Joel and Sylvia Miller. His father was an attorney and a graduate from Harvard University. Merton followed his father’s footsteps and enrolled in Harvard in 1940. Here, he studied economics and not law. Miller’s classmate was Robert M. Solow, a noted laureate of economic sciences.
1.2-CAREER AND EDUCATIONAL BACKGROUND
After receiving his bachelor’s degree in 1943, Miller worked as an economist in the Treasury Department and the Federal Reserve, during World War II. Nine years later, in 1952, Merton acquired his Ph.D. in Economics from the John Hopkins University. He chose this particular institution because Fritz Machlup, the then leading economist, was part of the teaching faculty. Owing to his excellence in the field of active research in finance, his first academic appointment was in the London School of Economics as a visiting assistant lecturer. In 1958, Miller collaborated with his colleague, Frank Modigliani, from the Carnegie Institute of Technology, now called Carnegie Mellon University. Together, they compiled a paper on ‘The Cost of Capital, Corporate Finance and the Theory of Investment’, which objected to the traditional view of corporate finance, i.e. a corporation can reduce its cost of capital by finding the right debt-to-equity ratio. Instead, the Modigliani-Miller theorem (M&M theorem) re-instated that there is no right ratio and managers must decrease tax liability and increase corporate net wealth. This would, in turn, facilitate debt ratio chips fall. Following this marvellous proposition, in 1961, Miller became a professor at the Graduate School of Business, University of Chicago. It was during this time that Miller began writing and co-authoring books and had eight of them published under his name. From 1966-1967, Merton worked as a Professor of Economics in the University of Louvain, Belgium. This well-renowned economist became a Fellow of the Econometric Society in 1975. One year later, Miller was appointed the President of the American Finance Association. Miller was the Public Director on the Chicago Board of Trade between 1983 and 1985. His research interests shifted towards the economic and regulatory problems of the financial services industry such as the securities and options exchanges. He joined the Chicago Mercantile Exchange as the Chairman of the academic panel for a post-mortem report on the Crash of October 19-20 in 1987. In 1990, Miller became the Public Governor of the Chicago Mercantile Exchange. During the course of his career, Miller proclaimed to be an activist supporter of free-market solutions to economic problems, just like laureates such as Milton Friedman (1976), Theodore Schultz (1979) and George Stigler (1982). In 1990, due to his commendable contribution in the theory of financial economics, Merton H. Miller together Harry Markowitz and William Sharpe was honored with the Nobel Memorial Prize. He was a part of the University of Chicago until his retirement in 1993, although he continued teaching even after that. It was believed that Miller’s theories and had a strong influence in changing the Wall Street and investment habits in America
Merton Miller was married to Eleanor and they had three daughters, namely Pamela Chwedyk (1952), Margot Horn (1955) and Louise Lorber (1958). After his first wife’s death in 1969, Miller married a woman named Katherine. His daughters, grandsons, his wife and he lived in a townhouse in Hyde Park. He also owned a working farm in Woodstock, Illinois. In his spare time, Miller indulged in bush cutting and gardening
Fama, Eugene F. and Merton H. Miller. 1972. The Theory of Finance. New York, NY: Holt, Rinehart and Winston. ISBN 0030867320 Miller, Merton H. 1986. The Academic Field of Finance: Some Observations on its History and Prospects. Chicago, IL: University of Chicago Miller, Merton H. 1991. Financial Innovations and Market Volatility. Cambridge, MA: Blackwell. ISBN 1557862524 Miller, Merton H. 1997. Merton Miller on Derivatives. New York, NY: Wiley. ISBN 0471183407 Miller, Merton H. 1998. "The M&M Propositions 40 Years Later." European Financial Management, 4(2), 113. Miller, Merton H. 2005. Leverage. Journal of Applied Corporate Finance. 17(1), 106-111. Miller, Merton H. and F. Modigliani. 1958. "The Cost of Capital, Corporation Finance and the Theory of Investment." American Economic Review, 48(3), 261-297 Miller, Merton H. and F. Modigliani. 1963. "Corporate income taxes and the cost of capital: a correction." American Economic Review, 53(3), 433-443. Miller, Merton H. and Myron S. Scholes. 1982. Dividends and taxes some empirical evidence. Chicago, IL: Center for Research in Security Prices, Graduate School of Business, University of Chicago. Miller, Merton H. and Charles W. Upton. 1974. Macroeconomics: A neoclassical introduction. Homewood, IL: R.D. Irwin. ISBN 0256015503
Received Nobel Memorial Prize in Economic Sciences in 1990
4- THEORY PRESENTED BY MILLER WITH MODIGLIANI MM THEORY 4.1-DEFINITION
The Modigliani–Miller theorem forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process, 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 Modigliani–Miller theorem is also often called the capital structure irrelevance principle.
4.2-ASSUMPTIONS OF MM THEORY
The basic M&M proposition is based on the following key assumptions:
No taxes No transaction costs No bankruptcy costs Equivalence in borrowing costs for both companies and investors Symmetry of market information, meaning companies and investors have the same information No effect of debt on a company's earnings before interest and taxes
4.3-PROPOSITIONS OF MM THEORY
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 Modigliani–Miller theorem states that the value of the two firms is the same.
where is the value of an unlevered firm = price of buying a firm composed only of equity, and is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity. Another word for levered is geared, which has the same meaning.
To see why this should be true, 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.
is the required rate of return on equity, or cost of equity. is the company unlevered cost of capital (ie assume no leverage). is the required rate of return on borrowings, or cost of debt. 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 individuals and corporations borrow at the same rates.
This discussion also clarifies the role of some of the theorem's assumptions. We have implicitly assumed that the investor's cost of borrowing money is the same as that of the firm, which need not be true in the presence of asymmetric information, in the absence of efficient markets, or if the investor has a different risk profile to the firm.
WITH TAXES Proposition I:
VL is the value of a levered firm.
is the value of an unlevered firm. is the tax rate ( ) x the value of debt (D) the term assumes 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 nondeductible
is the required rate of return on equity, or cost of levered equity = unlevered equity + financing premium. is the company cost of equity capital with no leverage (unlevered cost of equity, or return on assets with D/E = 0). is the required rate of return on borrowings, or cost of debt. is the debt-to-equity ratio. is the tax rate.
The same relationship as earlier described stating that the cost of equity rises with leverage, because the risk to equity rises, still holds. The formula however has implications for the difference with the WACC. Their second attempt on capital structure included taxes has identified that as the level of gearing increases by replacing equity with cheap debt the level of the WACC drops and an optimal capital structure does indeed exist at a point where debt is 100% The following assumptions are made in the propositions with taxes:
corporations are taxed at the rate on earnings after interest, no transaction costs exist, and individuals and corporations borrow at the same rate
4.4-DRAWBACKS , ISSUES IGNORED BY MM THEORY
Bankruptcy costs Agency costs Debt and the incentive to manage efficiently Institutional restrictions Transaction costs
Miller died on June 3, 2000 of lymphoma at the age of 77. The dean of the Chicago University, Robert Hamada, said, “Miller was the founder of modern finance and the person who fathered the discipline from an institutional field of study to one that is truly a legitimate and well-accepted part of economics and business
6-Merton H. Miller Timeline:
1923: Merton H. Miller was born on May 16 in Boston, Massachusetts. 1943: He received his bachelor’s degree from Harvard University and worked in the Treasury Department and Federal Reserve. 1952: Received a Ph.D. in Economics from John Hopkins University. 1958: Modigliani-Miller Theorem was proposed in the paper ‘The Cost of Capital, Corporate Finance and Theory of Investment’. 1961: Appointed as ‘Robert R. McCormick Service Professor’ at the Graduate Business School in Chicago University was given to him. 1966-1967: Worked as a Professor of Economics in the University of Louvain, Belgium. 1975: Miller became a Fellow of the Econometric Society. 1976: He was appointed President of the American Finance Association. 1983-1985: Served as the Public Director of the Chicago Board of Trade. 1987: Miller joined the Chicago Mercantile Exchange as Chairman for a postmortem report on the Crash of October 19-20. 1990: Merton Miller, became the Public Governor of the Chicago Mercantile Exchange. The same year, he won the Nobel Memorial Prize for Economics, along with Harry Markowitz and William Sharpe. 1993: He retired from the University Of Chicago Graduate School Of Business. 2000: June 3, at the age of 77, Miller died of lymphoma
7- REFRENCES OF TOPIC http://en.wikipedia.org/wiki/Modigliani%E2%80%93Miller_theorem http://www.thefamouspeople/profiles/merton-h-miller-283.php http://www.investopedia.com/walkthrough/corporate-finance/5/capitalstructure/modigliani-miller.aspx
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