The Nobel Prize

Merton H. Miller (1923–2000)

Merton Miller was born in Boston, Massachusetts, USA in 1923. He studied economics as an undergraduate at Harvard University, where one of his contemporaries was fellow Nobel Laureate Robert Solow. Miller was awarded a BA in 1944. After graduation he worked as an economist, first in the US Treasury’s Division of Tax Research from 1943 to 1947, and subsequently in the Research and Statistics Division of the Board of Governors of the Federal Reserve. In 1949, Miller left government service for postgraduate research at Johns Hopkins University. He was awarded a PhD by Johns Hopkins in 1952.

Miller’s academic life began in the UK, where he was assistant lecturer at the London School of Economics in 1952–53. He returned to the United States in 1953 as Assistant Professor of Economics and Industrial Administration at Carnegie Institute of Technology (now Carnegie-Mellon University); he was promoted to associate professor in 1958. In 1961 Miller moved to the University of Chicago as Professor of Finance and Economics, before becoming Edward Eagle Brown Professor of Banking and Finance in 1966. Apart from two visiting professorial appointments at the University of Louvain and the University Faculty of Mons, both in Belgium, in 1966 and 1973, respectively, Miller remained at Chicago for the rest of his career where he was subsequently Leon Carroll Marshall Distinguished Service Professor (1981–87), Robert R. McCormick Distinguished Service Professor (1987–93) and, from 1993, Robert R. McCormick Distinguished Service Professor Emeritus. Miller died on 3 June 2000.

Miller’s professional activities were wide ranging. He was public director of the Chicago Board of Trade from 1983 to 1985 and public director of the Chicago Mercantile Exchange from 1990. Also in 1990, Miller was a member of the New York Stock Exchange Advisory Panel on Market Volatility and Investor Confidence.

Miller was a fellow both of the Econometric Society and the American Academy of Arts and Sciences, and a distinguished fellow of the American Economic Association. He was also a senior fellow of the American Association of Financial Engineers. In 1975 he served as vice-president of the American Finance Association and in 1976 he was the association’s president. In 1990 Miller was awarded the Nobel Memorial Prize in Economics, together with Harry Markowitz and William Sharpe, ‘for their pioneering work in the theory of financial economics’, and more specifically in Miller’s case ‘for his fundamental contributions to the theory of corporate finance’ (Nobel Foundation, 2004).

Miller, together with the 1985 Nobel Laureate Franco Modigliani, his co-author in papers specifically acknowledged by the Royal Swedish Academy, is a founder of the modern theory of corporate finance (Myers, 1991). In a path-breaking article in the American Economic Review, ‘The Cost of Capital, Corporation Finance and the Theory of Investment’, Modigliani and Miller (1958) argued that discussions of rational investment and financial policy had up until then lacked theoretical foundation (see also Modigliani and Miller, 1959). The purpose of their paper was to construct an appropriate theory based on the relationship between corporate financial structure and market valuation. In doing so, they reached what was at the time a startlingly novel conclusion: that the value of a firm was independent of its capital structure. So long as capital markets functioned perfectly, an implication of equilibrium was that the issuing of new debt or equity did not appear to carry any particular valuation consequences for the firm. This has since become known as the first Modigliani and Miller value-invariance proposition. Modigliani and Miller developed their initial 1958 contribution in two further papers that are also acknowledged in Miller’s Nobel citation: Modigliani and Miller (1963; 1966).

Modigliani and Miller’s analysis can be understood by reference to the absence of opportunities for arbitrage by both firms and investors in debt and equity transactions. If a firm could alter its market value by modifying its debt–equity structure, it would be possible for individual bond and shareholders to undertake parallel transactions that would guarantee them arbitrage profits. An investor could modify his or her portfolio of bonds and shares and realise the resulting increase in portfolio value as profit. That investors cannot act in this way implies that the value of a firm must indeed be independent of its capital structure in the context of equilibrium in perfect capital markets.

Following Varian (1987; 1993), note that this argument does not contradict the fundamental insight due to Markowitz (see entry in this volume) that asset diversification is an essential element in investor portfolio choice. As Markowitz argued, diversification among assets is sensible because it reduces uncertainty for investors. Given the value additivity principle – which states that the value of a portfolio simply reflects the combined prices of the assets of which it is composed – it is apparent that equilibrium asset prices already incorporate any value that could be achieved by portfolio restructuring. Moreover, because investors have the same free access to capital markets as firms, it follows that diversification for risk-management purposes can be done by investors themselves through the medium of portfolio choice; all investors require of firms is that they maximise value (Myers, 1991). The simple message of Modigliani and Miller’s first value-invariance proposition is that this cannot be achieved by changes in capital structure.

Modigliani and Miller’s second value-invariance proposition states that, given a firm’s investment decision, its dividend policy has no influence on the value of its shares and, therefore, its market value (Miller, 1988; Royal Swedish Academy of Sciences, 1991). Miller (1988) offers a simple explanation of this second proposition. To finance, for example, a higher dividend, as investment is held given, part of the firm must be sold off. In this way, dividend policy becomes ‘just a wash – a swap of equal values not much different in principle from withdrawing money from a passbook savings account’ (ibid., p. 104). It has, in other words, no impact on the share price or the market value of the firm.

In a retrospective on the Modigliani–Miller propositions, Miller (1988) considered that the first invariance proposition – that a firm’s capital structure does not influence its market value – had been fully incorporated into economic theory. He noted, however, that doubts about the practical application of the proposition persisted on the back of many instances of real-world association between changes in the capital structures of firms and their values. Similar concerns regarding the second invariance proposition had also surfaced as numerous announced dividend changes appeared to prompt share price reactions. In fact, as Myers (1991) notes, Modigliani and Miller in their 1958 paper had anticipated that market frictions attributable to, for example, taxes might result in empirical challenges to their analysis. In the context of the first proposition, Miller (1977; 1988) disputed the argument that the tax advantages of debt financing gave rise to some optimal tax structure for the firm (the Modigliani and Miller contention, of course, was that there was none). Similarly, Modigliani and Miller (1961) suggested that share price reactions to dividend announcements were not an empirical refutation of the second proposition but reflected informational asymmetries between a firm’s executives and other agents in the market: in other words, dividends could carry some ‘informational content’ about a firm’s future earnings prospects (see also Miller, 1988; Myers, 1991).

Miller (1988, p. 118) acknowledges that ‘the open questions about [the invariance] propositions have long been empirical ones’ (see also Miller, 1991). Implicit in this statement is the justified claim that Modigliani and Miller’s work has provided the foundation upon which the development of research in corporate finance has subsequently been based (Royal Swedish Academy of Sciences, 1991; see also Miller’s 1972 book, with Eugene Fama, The Theory of Finance). A selection of Miller’s contributions to finance and economics has been published in two volumes edited by Bruce Gundy (Miller, 2002).

Main Published Works
(1958), ‘The Cost of Capital, Corporation Finance and the Theory of Investment’, (with F.
Modigliani), American Economic Review, 48, June, pp. 261–97.

(1959), ‘The Cost of Capital, Corporation Finance and the Theory of Investment. Reply’
(with F. Modigliani), American Economic Review, 49, September, pp. 655–69.

(1961), ‘Dividend Policy, Growth and the Valuation of Shares’ (with F. Modigliani), Journal of
Business, 34, October, pp. 411–33.

(1963), ‘Corporate Income Taxes and the Cost of Capital: A Correction’ (with F. Modigliani),
American Economic Review, 53, June, pp. 433–43.
(1966), ‘Some Estimates of the Cost of Capital in the Electric Utility Industry, 1954–57’ (with
F. Modigliani), American Economic Review, 56, June, pp. 333–91.
(1972), The Theory of Finance (with E.F. Fama), New York: Holt, Reinhart & Winston.
(1977), ‘Debt and Taxes’, Journal of Finance, 32, May, pp. 261–75.
(1988), ‘The Modigliani–Miller Propositions After Thirty Years’, Journal of Economic Perspectives, 2, Fall, pp. 99–120.
(1991), ‘Leverage’, Journal of Finance, 46, June, pp. 479–88.
(2002), Selected Works of Merton H. Miller: A Celebration of Markets (ed. B.D. Gundy), 2 vols, Chicago: University of Chicago Press.

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