Management

The World of Modigliani and Miller

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Financial analysis has never been an exact science. Occasionally, the theoretical models upon which it is based are even “bad” science. The root cause is that economic decisions undertaken in a real world of uncertainty are invariably characterised by hypothetical human behaviour, for which there is little empirical evidence. Thus, a financial model may satisfy a fundamental requirement of all theory construction. It is based on logical reasoning. But if the objectives are too divorced from reality, or underpinned by simplifying assumptions that rationalise complex phenomena, the analytical conclusions may be invalid.
Nevertheless, all theories, whether bad or good, still serve a useful role.
• At worst, they provide a benchmark for future development to overcome their deficiencies, which may require correction, or even a thorough revision of objectives.
• At best, they serve to remind us that the ultimate question is not whether a theory is an abstraction of the real world. But does it work?
The purpose of this study is to illustrate the development of basic financial theory and what it offers, with specific reference to the seminal work of two Nobel Prize economists who came to prominence in the 1950s and have dominated the world of finance ever since:
Franco Modigliani (1918–2003) Merton H. Miller (1923–2000)
The text’s inspiration is based on readership feedback from my bookboon series, which welcomed various explanations of Modigliani and Miller’s controversial hypothesis that identical financial assets (for example, two companies, their individual shares, or capital projects) cannot be valued and traded at different prices.
Many readers also mentioned that this application of the economic “law of one price”, which permeates the series, concerning the irrelevance of dividend policy, capital structure and its portfolio theory implications, should be published in a single volume to focus their studies.
I agree, whole-heartedly.

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English

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978-87-403-1062-7

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NONE

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