Modigliani, along with his co-worker, Merton Miller, proposed a theorem concerning corporate economics, called the Modigliani-Miller Theorem.
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maiamalie (student)
Franco Modigliani
Franco Modigliani was an Italian economist, from the early 1940’s to the early 1990’s. His main work in financial economics took place at the Massachusetts Institute of Technology, in Cambridge, Massachusetts, where he worked in the MIT Sloan School of Management and the MIT Department of Economics. During his career, he also taught at Columbia University and Bard College as an instructor in economics and statistics, before earning his Doctorate of Social Science from the New School for Social Research. While teaching at Carnegie Mellon University in the 1950’s, Modigliani formulated the Modigliani-Miller Theorem, along with his partner, Merton Miller. This theorem largely impacted the way corporate finance worked, because it demonstrated that the value of a firm is not affected by whether it is financed by equity or debt. Modigliani also created the life-cycle hypothesis, which attempted to explain the level of saving in the economy. He suggested that consumers would have a stable level of consumption during their lifetime, by saving during their working years, and spending during their retirement. For his work in economics, Modigliani received many prestigious awards, such as the Nobel Prize in Economics in 1985 and the Massachusetts Institute of Technology James R. Killian Faculty Achievement Award.
While working at Carnegie Mellon University in Pittsburgh, Pennsylvania, Modigliani, along with his co-worker, Merton Miller, proposed a theorem concerning corporate economics, called the Modigliani-Miller Theorem. Proven under the assumption of no taxes, the Modigliani-Miller Theorem is made of two propositions that can be extended to suit an economic situation that requires taxes. The theorem states that if one considers two firs which are identical with the exception of their financial structures, one is unlevered (named Firm U), or financed by equity only, and the other (named Firm L) is levered; financed partly by equity, and partly by debt, the value of those to firms would be the same. The theory originally applied to an economy with no taxes. In this situation, VU = VL where VU is the value of an unlevered firm composed only of equity, meaning the price of buying a firm that is only composed of equity, and VL is the value of a levered firm, meaning the price of buying a firm that is composed of some mix of debt and equity. This proposition was stated under the assumptions that taxes do not exist, no transaction costs exist, and individuals and corporations borrow at the same rate. This proposition should be true, for example, if an investor was considering buying either firm L or U. Rather than purchasing the shares of levered firm L, the investor could purchase the shares of firm U and borrow the same amount of money that firm L does. Therefore, the price of L has to be the same as the price of U minus the money borrowed, which is equivalent to the debt of firm L. Proposition II stated that a higher debt to equity ratio leads to a higher required return on equity, because of increased risk for equity holders in a company with debt. [ke=ko+D/E(ko-kd)] (ke meaning the required rate of return on equity, ko being the company unlevered cost of capital, kd being the required rate of return on borrowings, or cost of debt, D/E being the debt to equity ratio) As an alternative plan, Modigliani and Miller created a second method within their Proposition II: As the leverage (D/E) increases, the weighted average cost of capital (ko) stays the same.
