The Modigliani-Miller Theorem at 60: The

Long-Overlooked Legal Applications of

 
2018 marks the sixtieth anniversary of the publication of Franco Modigliani and Merton
Miller’s The Cost of Capital, Corporation Finance, and the Theory of Investment, which
purports to demonstrate that a firm’s value is independent of its capital structure. Widely
hailed as the foundation of modern finance, their article is little known by lawyers and
legal academics even though it led to many major economic advances, such as agency
costs and asymmetric information, recognized and used throughout the law today. The
legal profession’s lack of familiarity with these Nobel Prize-winning authors and their
work is not merely an oversight; it is a missed opportunity. When inverted, the
Modigliani-Miller theorem describes the mechanisms through which capital structure
can affect value. This “reverse” Modigliani-Miller theorem provides a powerful
framework that can be extremely useful to legal academics, practicing attorneys, and
judges.
Introduction
In June 1958, two young economists, Franco Modigliani and Merton Miller, published an
article, The Cost of Capital, Corporation Finance, and The Theory of Investment in
the American Economic Review. That article, which directly challenged then-
conventional financial orthodoxy, is today widely acknowledged as the foundation of the
modern academic discipline of finance. 1 Yet, the article, which is still read by nearly all
economics and finance graduate students, is little known among lawyers and legal
academics, many of whom have never heard of or have only a passing acquaintance with
the authors’ names and their work. Nonetheless, MM (as the pair of authors, their joint
articles, and the theorems they contain are all colloquially referred to by economists)
has long been implicitly used throughout the legal profession, although the debt has only
been occasionally acknowledged and their work is rarely directly and knowingly applied
by legal academics.2 That oversight is unfortunate because the first MM theorem, when
reversed, provides a powerful framework with broad applications throughout the law. As
the sixtieth anniversary of the publication of MM’s first article approaches, it is time for
the legal profession to add the reverse MM theorem to the lawyer’s toolkit, 3 alongside
other well-known economic ideas, such as the Coase theorem.4
The rest of this Essay is organized as follows. After describing MM and its development,
I introduce the reverse MM theorem—the idea that if capital structure matters it must
work through one of the original MM theorem’s assumptions. The three following
sections then describe how the reverse MM theorem can be used by legal academics,
practicing lawyers, and judges in their work. In each section, I provide one or more
examples to illustrate how the reverse MM theorem can serve as a framework to address
a broad range of recurring, but challenging legal issues. I then speculate as to why the
reverse MM theorem is not already widely known and used by lawyers before offering a
conclusion.
I. History
Modern business school finance departments are stocked with Ph.D.s whose scholarship
tends to focus on abstract questions with real-world applications. Sixty years ago, the
situation was different.5 Finance departments were much smaller and something of a
backwater. The field lacked mathematical precision and conceptual rigor, relying heavily
on accounting conventions, rules of thumb, and anecdotes.6 The prevailing view at the
time was that the impact of leverage on the value of a firm was “complex and
convoluted.”7 Debt was generally considered preferable to equity because it was cheaper
(the stated return on debt was less than the implied return on equity 8 and because interest
could be deducted, whereas dividends could not; however, there was thought to be some
unspecified upper limit on value-increasing debt because the risk of corporate bankruptcy
and the interest rate increased with leverage. However, none of these intuitions had been
formalized.9
With their 1958 article, MM directly challenged the prevailing thinking that debt was
cheaper than equity and that each firm had an optimal capital structure. They argued that
under certain idealized assumptions the amount of debt had no impact on firm
value.10 Expressed more confrontationally, MM averred that their finance colleagues were
wasting their time and their clients’ money trying to ascertain what a firm’s optimal
capital structure was because one capital structure was as good as any other. 11 That idea,
which is also MM’s principal substantive result and is today known as the capital
structure irrelevancy proposition, or more succinctly, as MMI, 12 has been called “the
bombshell assertion.”13 As with many bold ideas, the underlying intuition is extremely
simple. In an interview after Modigliani won the Nobel Prize in Economics, Miller (who
subsequently won the prize, too) analogized their irrelevancy proposition to slicing a
pizza. A pizza can be cut into as many slices as desired but doing so does not change the
pizza’s size.14
Similarly, MM argued that the firm’s capital structure divides the firm’s cash flows, but
because it does not change those cash flows, it does not affect the overall value of the
firm, which is just the present value of all of the firm’s cash flows.
Although MM’s main result is most intuitively expressed by analogy, they presented their
argument formally. MM began their formal argument with a series of idealized
assumptions. Although there are different ways to state the MM assumptions, from a
lawyer’s perspective, the most intuitive and helpful listing of the MM assumptions is
probably as follows:
Efficient capital markets – All investors have access to the same information, which they
process in the same way. As a result, all investors agree on the market value of all cash
flow streams.
Frictionless markets – There are no transaction costs. Contracts can be costlessly written
to cover all contingencies and can be costlessly enforced.
No taxes (or other regulations) – There are no taxes at the firm or the individual investor
level. There are also no government regulations, or at least no regulations that relate to or
are affected by capital structure.
Only cash flows matter – Investors care only about the cash flow generated by an
investment. Alternatively, no investments generate nonpecuniary benefits, such as shelter
(owner-occupied housing) or aesthetic appreciation (art).
Using only the above four assumptions, MM showed that a firm could not change its
value by adjusting its leverage. MM proved their central claim by assuming the contrary
result (that the firm could change its value by adjusting its leverage) and then showing
that the result could not persist in a market with rational investors.
Because MM’s capital structure irrelevancy theorem was so out-of-step with
conventional thinking and practice, it was initially met with deep skepticism. 15 Many
thought the theorem was simply wrong: that the conclusion did not follow from the
assumptions. However, after some back-and-forth and various technical corrections,
economists concluded that the argument was correct as a matter of theoretical economics.
Given the initial assumptions (efficient and frictionless markets, no taxes, and only cash
flows matter) the result (a firm’s value was independent of its capital structure)
held.16 Next, skeptics questioned whether the assumptions were so inaccurate as to render
the theorem true as a matter of internal logic, but not very useful. Most practicing finance
professionals reached that conclusion and they largely ignored MM’s work. Academic
economists, however, took a different approach. For a time, many accepted the theorem
as fairly accurate and turned their attention to other issues, but they did not ignore
MM.17 Instead, they built modern finance upon it.18
The economists, whether or not they accepted the MM capital structure irrelevancy result,
mined MM’s formal argument. By appealing directly to the economic principle of one
price—the notion that two perfect substitutes will sell for the same price—the MM proof
introduced the idea of arbitrage into financial economics. 19 Since its introduction by MM,
financial economists have been employing arbitrage arguments in order to develop new
insights.20 Consider two major examples from the 1960’s and 1970’s. The first example is
the capital asset pricing model (CAPM), which holds that investments are priced
according to their market risk (typically measured by beta – β), which cannot be
diversified away, not their unique risk, which can be eliminated through
diversification.21 The second example is the Black-Scholes option pricing model, which
recognizes that a call option is equivalent to holding a share of the underlying stock and
borrowing against that share.22Today, arbitrage is the cornerstone of financial economics.
Indeed, the MM proof has been called the “watershed between old and new finance.” 23
Economists, however, were not finished with capital structure. After a roughly twenty-
year hiatus, economists began to return to studying capital structure. 24 And when they did,
they recognized that the MM capital structure irrelevancy proposition provided the key to
understanding capital structure.
By that time, financial economists had recognized that the MM irrelevancy proposition
had wide application. Given the original MM assumptions, it follows that a broad array of
corporate actions, not just leverage, have no impact on firm value. Indeed, the MM
assumptions imply that the value of a firm is determined solely by the firm’s investments
or assets (the left side of the balance sheet), not how those investments are financed (the
right side of the balance sheet). Thus, for example, the MM assumptions also imply that
hedging activities, leasing versus owning, the form of legal organization, the
compensation structure, the state of incorporation and the legal rules that follow, and so
much more have no impact on firm value either. That suggests a tension, if not an
outright conflict, between the MM capital structure irrelevancy theorem and the goal of
understanding capital structure.
The key to reconciling this tension was to reverse or invert the MM irrelevancy theorem.
As Miller wrote in 1988, as part of a symposium on the thirtieth anniversary of the
publication of the first MM article, MM wrote their original article in order to dispel
much thinking about how capital structure can affect firm value. 25 However, by showing
which aspects of capital structure do not affect value, MM also showed how capital
structure can affect value.26 Thus, the power of MM is through the MM assumptions,
which describe how capital structure can impact firm value This idea is called the reverse
MM theorem, and it holds that capital structure can affect the overall value of the firm
only by releasing or withholding information, by decreasing or increasing transactions
costs, by decreasing or increasing taxes (or the costs of other regulations), or through the
allocation of assets with consumption elements. According to MM, the above is an
exhaustive list of how capital structure decisions can affect firm value.
The reverse MM theorem, thus, takes the original MM theorem and turns it on its head. It
replaces the idea that under certain assumptions capital structure does not affect the value
of the firm with the idea that capital structure affects firm value only to the extent that it
operates through the MM assumptions.27
Starting in the 1970s, economists began to mine the MM assumptions for insights into
how capital structure affects the total value of the firm. Consider the following two
examples from that decade. Michael Jensen and William Meckling argued that the
conflicting interests of the managers and the owners of a business generate agency costs,
which the owners seek to reduce by monitoring and writing contracts that bond their
employees with contingent payments.28 Thus, Jensen and Meckling developed a theory of
capital structure that exploits the notion that the second MM assumption, frictionless
markets, is false.
Around the same time, Stephen Ross recognized that managers are usually better
informed about a firm’s prospects than are its shareholders. Ross argued that mangers
could signal to shareholders that a firm’s prospects have improved by raising the firm’s
debt-to-equity ratio or declined by reducing that ratio. Ross argued that investors can
easily read these signals, which are credible because they are costly for managers to
send.29 Ross’s article, which was the first application of signaling theory to finance,
assumes that the first MM assumption, informationally perfect markets, is wrong.
The above are only two examples—albeit two very important and highly influential
examples—of how capital structure can impact value. Over the last forty years,
economists have developed many ideas in addition to the two above that illustrate how
capital structure can affect value in situations where the original MM assumptions do not
hold (Miller himself developed many of the ideas about taxes and value. 30). And some of
these ideas, including agency costs and signaling, have made their way into the lawyer’s
toolkit. However, the work of MM, which gave birth to these ideas, and which in the
form of the reverse MM theorem serves as a framework that organizes these and many
other ideas, has not been incorporated. That is unfortunate because the reverse MM
theorem is a powerful analytical tool with a wide range of legal applications.
II. Ivy Halls: Use by Legal Academics and Policy Makers
Scholars can use the reverse MM theorem for both positive and prescriptive analyses.
Positively, academics can use the theorem to understand why a particular structure is
used and how it has developed and changed over time. Implicit in the exercise is the
assumption that the observed structure is the structure that maximizes value. The theorem
is then being used to explain why the observed practice is optimal. Scholars can also use
the reverse MM theorem prescriptively to criticize existing structures and to develop
recommendations for improved structures.
A. Positive Analysis
Use of the reverse MM theorem for positive analysis is sometimes explicit in finance
scholarship,31 but it is rarely explicit in legal scholarship.32
Nonetheless, sophisticated legal academics frequently make arguments in the vein of the
reverse MM theorem. Such arguments often take the form that some capital structure is
optimal because it solves a particular informational, incentive, or tax problem, which is to
say it solves a problem relating to a failure of one of the MM assumptions. Contained
within that argument is usually a nod to the notion that the structure does not create or
amplify other problems—that it does not increase costs relating to a failure to meet the
other assumptions.
The practice of aircraft leasing, for example, can be readily understood through the
reverse MM theorem. Airlines have three alternatives to fund new aircraft: equity, debt,
or capital (long-term) leases.33 Among the three alternatives, airlines rarely purchase new
aircraft by issuing equity or using retained earnings. That is largely because equity
financing is subject to two levels of taxation—first at the corporate level and then at the
investor level—whereas borrowing and lease-financing incur only one level of
taxation.34 Thus, airlines rarely finance aircraft through equity because the tax cost, which
relates to the third MM assumption, is prohibitive.
If the airline were to borrow to purchase the aircraft, the airline could depreciate the
aircraft because the owner of tangible personal property is entitled to the depreciation
deductions on that property. Depreciation reduces income, and thus provides the owner of
the depreciable property with a tax benefit. Moreover, aircraft are eligible for accelerated
depreciation.35 These favorable depreciation rules make commercial aircraft a tax-
advantaged asset. Such assets are worth most to high-bracket taxpayers confident that
they will have the income to take full advantage of the deductions. 36 Airlines, however,
are not such taxpayers. The airline industry is capital-intensive (aircraft are expensive),
volatile, and low-profit. Accordingly, if the airlines took all of the depreciation
deductions from the aircraft they operated, they would frequently realize little or no value
from doing so. Thus, the aircraft lease and its close cousin, the leveraged aircraft lease,
were created in order to transfer the depreciation deductions from the airlines to other
taxpayers that value them more.
In an aircraft lease, a third party takes title and leases the aircraft to the airline. The lessor
as the aircraft’s owner uses the depreciation deductions to offset other income. The
airline benefits through a lower operating cost because the lessor accepts a reduced lease
rate. In effect, the airline transfers the depreciation tax benefits to the lessor in exchange
for a lower lease rate. In a simple lease, the lessor would purchase the aircraft for cash,
tying up capital. Because it is the lessor’s tax attributes—and only those tax attributes—
that make it the preferred owner, most aircraft leases are leveraged leases. In a leveraged
lease, a lender provides most of the capital required to purchase the aircraft.
For a brief period during the early 1980’s, there was a practice called safe harbor leasing
under which any transaction called a lease would be respected as such, even if it closely
resembled a sale.37 In that environment, lessors would transfer the full risk of ownership
to lessees. Because lessors had no residual risk from the aircraft (which was insured
during the lease), they passed nearly all of the tax benefits to lessees through lower lease
rates. Later in the 1980’s, the safe harbor leasing provisions were eliminated. 38 The
Internal Revenue Service (Service) would then challenge parties’ characterization of
transactions as leases if the purported lessors had too little residual risk (under the tax
law, ownership is not determined by who holds title, but rather by who has the benefits
and burdens of ownership.). If the Service’s challenge succeeded, it would treat the
nominal lessee as owner (and hence the lessee, not the lessor, would be entitled to the
depreciation deductions). Accordingly, aircraft leasing changed. Leasing remained, but
lessors took on more residual risk, which created agency problems because lessees
controlled the aircraft during the lease. The lease documentation became longer, and the
parties and their lawyers carefully negotiated and executed the leases so as to ensure that
the lessors retained the requisite amount of risk and that the resulting agency costs were
controlled. Lease payments also increased in order to compensate lessors for their
increased risk and their increased contracting and monitoring costs. 39 Thus, the
elimination of safe harbor leasing led to changes in the optimal capital structure because
it changed the trade-offs across the four MM assumptions.
Although aircraft leasing can be understood without reference to the reverse MM
theorem, the theorem focuses on the relevant issues—taxes and incentives—the optimal
balance among which changed as the legal regime changed. Used in this way, the reverse
MM theorem operates as a template to understand alternative transactional structures and
their development over time.
B. Prescriptive Analysis
The reverse MM theorem can also be used to criticize inefficient capital structures and to
suggest how those structures might be improved. The reverse MM theorem can be used
prescriptively because it asks the right question from an economic efficiency perspective
—what structure maximizes the total value of the firm—and provides a roadmap to
answer that question. In corporate law, the central issue of debate has long been the
allocation of control rights among corporate managers, directors, and shareholders.
Because directors are typically seen as passive, the corporate governance debate is
usually binary: one side argues that shareholders should have greater control rights and,
concomitantly, that managers should have less. The other side makes the opposite
argument: Managers should have greater control rights and shareholders should have less.
The arguments are often anecdotal, but they are increasingly econometric. These
competing views of the proper allocation of power between managers and shareholders
play out across such issues as staggered boards, waiting periods, and takeover defenses.
The first view, the shareholder primacy position, is often described as the agency model,
and it emphasizes the agency costs from having managers make decisions on behalf of
shareholders. As such, the agency model is a straightforward example of a violation of
the second MM assumption of frictionless markets. The latter view, the management
primacy position, is sometimes described as the commitment view. Under that view,
activist investors deter firms from making long-term, positive-net-present-value
investments that cannot be valued by the market. Thus, the commitment view is an
example of a violation of the first MM assumption of informationally perfect markets.
The debate usually takes the form of which approach is better—favoring managers or
shareholders—which is to say whether the agency costs from manager control are greater
than the costs resulting from imperfect information with shareholder control.
The reverse MM theorem suggests a different approach, one emphasizing the need for a
governance structure that maximizes the total value of the firm. A third alternative that
mediates between the above two polar positions is to appoint stronger, more independent
directors who can identify and value investments that cannot be publicly disclosed
(without losing value). Such directors would allow the firm to capture the benefits from
making long-term investments not accurately valued by the market without the costs of
managerial entrenchment. Hiring and empowering such directors has the potential to
increase firm value above that from either polar position because it takes seriously the
concerns expressed by both sides and looks to alleviate each side’s concerns without
exacerbating the other side’s concerns. This suggestion, in essence, is Ira Millstein’s
proposal for activist directors who partner with management, but who also take
responsibility for the corporation’s strategy.40 As Millstein writes, he favors a board-
centric approach to corporate governance by placing more activist directors in the
boardroom – people who will ask the tough questions, challenge management practices,
and resist those who put their own agendas ahead of those of the corporation and
investors like you. Choosing directors will require new diligence and care.41
Millstein developed his proposal for more activist directors without appeal to the reverse
MM theorem, but by drawing upon his lengthy and highly successful legal career. For
those who lack the in-depth knowledge and experience that comes from decades of
working at the pinnacle of the legal profession, the reverse MM theorem provides a
framework that should make it easier to develop and defend efficient new forms of
corporate governance and capital structure, because the theorem focuses inquiry on the
relevant issues and provides a lens through which those issues can be examined and
weighed.
Moreover, the observation or recommendation that directors should have more power is
only the beginning of the analysis. A more thorough and detailed response would
describe the additional duties directors take on, the powers they should have, and the
limitations there should be on their powers. In addition, a more thorough analysis would
describe how directors should be compensated and how much effort they should apply to
each firm. Although I do not know the value-maximizing answers to those questions, the
path to finding them runs through the reverse MM theorem, because the theorem directs
those using it to look for the structure that strikes the value-maximizing balance across
the MM assumptions.
C. Summary
The reverse MM theorem categorizes and partitions the various ways that capital
structure, which includes governance, can affect the total value of the firm. The reverse
MM theorem takes a large collection of seemingly unrelated concepts and organizes them
into categories of closely-related ideas. Once so organized, these concepts can be used
and applied more easily and systematically to understand and evaluate existing financial
practices and in the search for efficiency enhancing innovations. This organizational
framework is of particular use to scholars because it leads them to examine the structure
that maximizes value across the MM assumptions, which MM have shown is the value-
maximizing structure (because everything outside of its assumptions has no effect on
value). The reverse MM framework can be used both to understand capital structures and
how they change over time, as with aircraft leasing, and to criticize current practice and
develop new ideas, as with governance. The above examples only scratch the surface
where academics can use the reverse MM theorem to understand capital structure. 42