- Person
- Franco Modigliani
- Lived
- 1918–2003
- Field
- Economics & finance
- From
- Italian-American
The story
Until the mid-1950s, the study of corporate finance consisted mainly of descriptions of methods and institutions, with little theory. Basic questions, such as whether a company is worth more if it borrows or if it sells shares, had no rigorous answer.
Franco Modigliani, a refugee from Fascist Italy, was then a professor at the Graduate School of Industrial Administration of the Carnegie Institute of Technology. He and his colleague Merton Miller had limited experience in corporate finance, but they were assigned to teach it to business students. Finding the published material lacking, they set out to work out the answers themselves.
In 1958 they published The Cost of Capital, Corporation Finance and the Theory of Investment in the American Economic Review. Its central result, now known as the Modigliani–Miller theorem, shows that if financial markets work perfectly and there are no taxes or bankruptcy costs, the market value of a firm does not depend on whether it is financed by equity or by debt. The value is set by the returns the firm's assets are expected to earn. As MIT later summarised it, stock market values are determined mainly by what businesses are expected to earn in the future, not by the size and structure of their debt. In a second paper the two men showed that, for a given investment policy, a firm's value is also independent of its dividend policy.
The power of the theorem lies partly in its assumptions. By showing exactly when financing does not matter, it revealed why it does matter in the real world, for example because interest on debt is tax-deductible. In 1963 Modigliani and Miller published a correction that took corporate income taxes into account. The Nobel committee called the theorems a decisive breakthrough that introduced a new method of analysis to corporate finance.
The theorem became a cornerstone of the field, often called the capital structure irrelevance principle. The Royal Swedish Academy cited it as one of Modigliani's two key achievements when he won the 1985 Nobel Memorial Prize, and Miller won his own Nobel in 1990. Sloan School dean Richard Schmalensee said Modigliani played a decisive role in the intellectual development of corporate finance.
Why it matters
The theorem gave businesses, investors and regulators a clear framework for thinking about debt, risk and value that is still taught to every finance student.
About Franco Modigliani
Rome-born economist who fled Mussolini’s racial laws and, at MIT, explained how people save over a lifetime and how firms are valued, winning the 1985 Nobel Prize.
More about Franco Modigliani
- Franco Modigliani bridged Keynes and classical economicsFranco Modigliani’s 1944 doctoral paper, “Liquidity Preference and the Theory of Interest and Money”, integrated Keynes’s revolution with classical economics.
- Franco Modigliani explained how people save over a lifetimeWith his student Richard Brumberg, Franco Modigliani developed the life-cycle hypothesis of saving in 1953–54, a key reason for his 1985 Nobel Prize.
- Franco Modigliani built a model used by the Federal ReserveIn the late 1960s Franco Modigliani led the design of a large model of the US economy for the Federal Reserve, a tool that guided monetary policy for decades.
- Franco Modigliani introduced the NIRU unemployment conceptIn 1975 Franco Modigliani and his former student Lucas Papademos introduced the NIRU, the non-inflationary rate of unemployment, a concept still debated in monetary policy.
- Franco Modigliani helped found rational expectationsAt Carnegie Tech, Franco Modigliani and Emile Grunberg published a paper on predicting social events when people react to predictions, a pillar of rational expectations theory.
- Franco Modigliani inspired generations of MIT studentsFranco Modigliani taught at MIT for about 40 years. Paul Samuelson called him a great teacher whose students included Nobel laureate Robert Merton.
Sources
- Franco Modigliani Wikipedia
- Nobel laureate Franco Modigliani dies at 85 MIT News
- The Prize in Economic Sciences 1985: press release NobelPrize.org
- Modigliani–Miller theorem Wikipedia
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