Lecture 3: Fisher, Modigliani and Miller

Colin Rowat
Room 406, Ashley Building
University of Birmingham
Edgbaston B15 2TT
c.rowat@bham.ac.uk
0121 414 3754
web.bham.ac.uk/c.rowat
January 19, 2004

Contents
1 News 1

2 Fisher’s separation theorem 2

3 Capital structure irrelevance 4

1 News
• any questions from previous lecture?
• for class problems, assume years are points in
time
• Fisher separation theorem today helps

1
C. Rowat Economics of Corporate Finance

2 Fisher’s separation theorem

John Wesley: Make all the money you can.
Parishioner: Amen!
John Wesley: Save all the money you can.
Parishioner: Amen!
John Wesley: Give all the money you can.
Parishioner: Now he’s turned to meddling.

• capital markets in economic development:

◦ finance ideas: source of growth
◦ WDR chart for Soviet Union
◦ Asian crisis
• NPV calculations depend on:
◦ costs and revenues
◦ the appropriate opportunity cost of capital
• they do not depend on individual’s time pref-
erences
• but individuals do have different time prefer-
ences. e.g.
Ui (c0i, c1i) = u (c0i) + βiu (c1i) ;
where βi ∈ [0, 1].

2
C. Rowat Economics of Corporate Finance

• could differing individuals agree on undertak-

ing a project?
• with perfect capital markets, yes:
◦ suppose that each individual owns 21 the
project, which has NPV of π
◦ ability to borrow, lend at same rate, r
◦ utility maximisation problem thus
1 1
max Ui s.t. c0i + c1i ≤ π;
c0i ,c1i ≥0 1+r 2
if the project is their only source of wealth.
◦ ∴, increasing π loosens the budget con-
straint of both.
• with perfect capital markets, Wesley and the
parishioner could work together. Both agree
that NPV should be maximised. Their con-
sumption plans would then differ.

3
C. Rowat Economics of Corporate Finance

3 Capital structure irrelevance

• two basic questions in corporate finance:
1. when to undertake an investment?
2. how to finance it (e.g. debt or equity)?
• answer to the first: when NPV > 0
• question about the second: does it matter?
• e.g. supposing that there were two firms with
the same projects; if one has debt but the
other is debt-free, do their values differ?
• Modigliani-Miller: capital structure doesn’t
matter
• important result for two reasons:
1. challenged conventional wisdom
2. introduced formal proof techniques to fi-
nance (∴ clarified logic)
• intuition: laws of conservation of value
◦ imagine dividing a firm’s value as like slic-
ing up a pie

4
C. Rowat Economics of Corporate Finance

◦ the number of slices doesn’t change the

total size of the pie
• results first presented in Modigliani and Miller
(1958); they have been refined and clarified
since
• Miller (1988) reviews the results, their con-
sequences
• Modigliani wins the 1985 Nobel, Miller shares
the 1990 one

3.1 The assumptions

The assumptions underlying the Modigliani-Miller
capital structure theorem can be stated in a num-
ber of similar ways. The following are one set of
sufficient conditions.
COM1 competitive financial markets: agents can
borrow and save/lend at the same r;
COM2 complete financial markets: agents have
equal access to capital markets, allowing them
to issue and trade securities equally.

5
C. Rowat Economics of Corporate Finance

CON Firms’ financing decisions only affect the

wealth of their share and bondholders through
the value of the firm.
DEF bankruptcy is costless, merely rearranging
resources in society
FUT Firms’ future investment decisions do not
depend on their financing decisions.
INF there are no informational asymmetries: su-
pervision of managers is costless
TAX there are no taxes or transaction costs: se-
curities may be issued, traded and held cost-
lessly
• COM2 implies that the price of securities
does not reflect the issuer, only the payoff
stream.
• INF implies that managers do not need to
‘signal’ information that only they have to
the market by their financial structure deci-
sions.
• CON and FUT mean that the problem can
be considered in isolation: only direct returns
6
C. Rowat Economics of Corporate Finance

to shares and bonds need to be considered -

no one earns anything from working on bond
or share issues

3.2 The theorem

Under the assumptions above, a firm’s debt -
equity mix cannot affect its NPV.

3.3 Demonstration
• show that no arbitrage opportunities exist that
allow investors to make money ‘for free’
• suppose there are 2 firms:
1. both have made identical investments, which
earn returns π.1
2. Sf = market value of firm f ’s equity
3. Bf = market value of firm f ’s debt
4. ∴ Tf = Sf + Bf = total value of firm f
5. firm 1 is only financed by equity: T1 = S1
(not geared, unleveraged)
1
When there is uncertainty about future states of the world, we may consider two firms,
each of whose projects yield the same returns in all future states. These firms are said to
belong to the same ‘risk class’.

7
C. Rowat Economics of Corporate Finance

6. firm 2 has debt: T2 = S2 + B2 (geared,

leveraged)
7. bondholders are repaid at interest rate r
owns fraction α of firm 2

sell it and borrow αB2

has αS2
|{z} αB2 = αT2
+ |{z}
from share sale borrowed

buy firm 1 shares

keep it
αT2
owns fraction T1 of firm 1

 
 T2 
earns α (π − B2 r) earns α  π − B2 r 
| {z }  T 1
|{z}
|{z} 
return to shareholders loan repayment
return to shareholders

Figure 1: Arbitrage opportunity when T2 > T1

• suppose that T2 > T1; argue by contradiction

◦ T2 > T1 means that firm 1’s financing
structure is not optimal: it has the same
project as does firm 2, but is worth less
◦ Modigliani-Miller show that ‘no arbitrage’
does not allow this
8
C. Rowat Economics of Corporate Finance

◦ consider a shareholder in firm 2 (Figure 1)

1. holding the shares yields
α (π − B2r) (1)
2. ‘replication’ route:
∗ by COM2, sell its shares (earning
αS2)
∗ by COM1, 2 borrow αB2 at rate r
∗ ∴ has αT2 in cash
∗ by COM2, buy fraction α TT21 of firm
1’s shares
∗ earns
T2
α π − αB2r (2)
T1
◦ when T2 > T1, as assumed, equation 2 >
1 ⇒ arbitrage, a contradiction
◦ how does the shareholder make money?
∗ when the shareholder buys firm 1 shares,
it owns a fraction of firm 1’s project
∗ however, the shareholder has ‘financed’
it by a mix of debt and equity:
· selling firm 2 shares ‘issued’ equity
· borrowing ‘issued’ debt
9
C. Rowat Economics of Corporate Finance

∗ by COM1, 2, other agents (includ-

ing firm 1) could also have taken ad-
vantage of this arbitrage opportunity.
Thus, it should not persist: T1 should
be driven up by demand for its shares.
∗ can weaken assumptions COM1, 2:
only some agents need to be able to
undertake arbitrage
∗ COM2 has another role, not used in
this demonstration: what if there are
not two firms with the same project?
• to rule out T1 > T2, follow the argument in
Figure 2

References
Merton H. Miller. The Modigliani-Miller propositions after thirty years. Journal
of Economic Perspectives, 2(4):99 – 120, Fall 1988.

F. Modigliani and M. Miller. The cost of capital, corporation finance, and the
theory of investment. American Economic Review, 48:261–297, 1958.

10
C. Rowat Economics of Corporate Finance

owns fraction α of firm 1

sell it

has αS1 = αT1

keep it convert to firm 2 shares, bond

owns fraction α TT12 of firm 2, α TT12 B2 bonds

T1 T1
earns απ earns α (π − B2 r) + α B2 r = α TT21 π
| T2 {z } | T{z
2 }
share returns bond return

Figure 2: Arbitrage opportunity when T1 > T2

11