Why Financial Structure Matters

Abstract

[This is a comment on “The Modigliani-Miller Propositions after Thirty Years” by Merton H. Miller in this same issue.] The 1958 paper by Franco Modigliani and Merton Miller has been justly hailed as a landmark in the modern theory of finance. What has not been sufficiently emphasized is the importance of the paper to the development of economic theory and practice. Indeed, it is ironic that a paper which purportedly established that one need not pay any attention to financial structure -- that financial structure was irrelevant -- should have focused economists' attention on finance. Again ironically, some of the most productive responses to the MM results have come from those who did not feel able to accept the conclusion that financial policy is irrelevant. The MM results forced these skeptics to identify which of the assumptions underlying the MM theorem should be modified or rejected. The attention of economists during the past 30 years has focused on four assumptions underlying the model: first, that firms can be identified by “risk class”; second, that individual borrowing can substitute for firm borrowing; third, that investors have full information about the returns of the firm; and fourth -- the importance of which MM themselves recognized -- is that there are no taxes, or at least tax policy does not treat debt and equity differentially. The question has been not so much whether these assumptions are “realistic,” but whether, or under what circumstances, altering these assumptions leads to situations where financial structure does indeed matter.