Merton Miller

21
Finance guru Miller

Transcript of Merton Miller

Miller

Date Of Birth16 May 1923

Place of BirthBoston United States

Fathers nameSylvia Miller Attorney from Harvard University

In 1943 economist in the Treasury Department and the Federal Reserve In 1952 Ph.D. in economics at the John Hopkins University

First academic appointment London School of Economics visiting assistant lecturer. In 1958 compiled a paper on The Cost of Capital, Corporate Finance and the Theory of Investment,

In 1961 professor at the Graduate School of Business, University of Chicago Appointed the President of the American Finance Association Joined the Chicago Mercantile Exchange as the Chairman 1987 In 1990, Miller became the Public Governor of the Chicago Mercantile Exchange

Biggest achievement was The Modigliani-Miller theorem 'Merton Miller on Derivatives In 1990 Nobel Memorial Prize.Part of the University of Chicago until his retirement in 1993 Miller died on June 3, 2000

Works Built-In Flexibility co-authored with R. A. Musgrave in 1948. An Income Effect of Changing Interest Rates co-authored with M. I. White in 1951. A Model of Optimal Programming of Railway Freight Train Movements co-authored with A. Charnes in 1956. Mathematical Programming and the Evaluation of Freight Shipment Systems co-authored with A. Charnes in 1957. The Cost of Capital, Corporation Finance and the Theory of Investment co-authored with F. Modigliani in 1958. An Application of Linear Programming to Financial Budgeting and the Costing of Funds co-authored with A. Charnes and W. W. Cooper in 1959. The Carnegie Tech Management Game co-authored with K. Cohen et al. in 1960. Dividend Policy, Growth and the Valuation of Shares co-authored with F. Modigliani in 1961. Corporate Income Taxes and the Cost of Capital: A correction co-authored with F. Modigliani in 1963. The Corporation Income Tax and Corporate Financial Policies in 1963. Horizon Rules for a Class of Stochastic Planning Problems co-authored with A. Charnes and J. Dreze in 1966. Some Estimates of the Cost of Capital in the Electric Utility Industry co-authored with F. Modigliani in 1966. A Model of the Demand for Money by Firms co-authored with D. Orr in 1966. A Model of the Demand for Money by Firms: Extensions of Analytical Results co-authored with D. Orr in 1968. The Theory of Finance co-authored with E. F. Fama in 1972. Macroeconomics: A Neoclassical Introduction co-authored with C. Upton in 1974. Leasing, Buying and the Cost of Capital Services co-authored with C. Upton in 1976. Debt and Taxes in 1977. An Approach to the Regulation of Bank Holding Companies co-authored with F. Black and R. A. Posner in 1978. The Stochastic Properties of Velocity and the Quantity Theory of Money co-authored with J. P. Gould, C. R. Nelson and C. Upton in 1978. Prices for State-Contingent Claims: Some Estimates and Applications co-authored with R. Banz in 1978. Dividends and Taxes co-authored with M. Scholes in 1978. Dividends and Taxes: Some Empirical Evidence co-authored with M. Scholes in 1982. A Test of the Hotelling Valuation Principle co-authored with C. Upton in 1985. Dividend Policy under Asymmetric Information co-authored with K. Rock in 1985. Behavioral Rationality in Finance: The Case of Dividends in 1986. Economic

Costs and Benefits of the Proposed One-Minute Time Bracketing Regulation co-authored with S.J. Grossman in 1986. Financial Innovation: The Last Twenty Years and the Next in 1986. Liquidity and Market Structure co-authored with S.J. Grossman in 1988. The Modigliani-Miller Propositions after Thirty Years in 1988. Margin Regulation and Stock Market Volatility co-authored with D. Hsieh in 1990. The Crash of 1987: Bubble or Fundamental? in 1990. Autobiography in 1990. Financial Innovations and Market Volatility in 1991. Leverage in 1991. Tax Obstacles to Voluntary Corporate Restructuring in 1991. Financial Innovation: Achievements and Prospects in 1992. Index Futures and Market Volatility: What Does the Evidence Show? in 1992. Index Arbitrage: Villain or Scapegoat in 1992. Are the Discounts on Closed-End Funds a Sentiment Index? in 1993. Is American Corporate Governance Fatally Flawed? in 1994. Functional Regulation in 1994. Metallgesellschaft and the Economics of Synthetic Storage co-authored with C. L. Culp in 1995. Do the M&M Propositions Apply to Banks? in 1995. Merton Miller on Derivatives in 1997. Clustering and Competition in Asset Markets co-authored with S. J. Grossman, K. R. Cone, D. R. Fischel and D. J. Ross in 1997. The M&M Propositions after 40 Years in 1998. Value at Risk: Uses and Abuses co-authored with C.L. Culp and A. Neves in 1998. The Derivatives Revolution After Thirty Years in 1999. The History of Finance in 1999

CAPITAL STRUCTURE IRRELEVANCE PRINCIPLE value of a firm is unaffected by how that firm is financed Otherwise arbitrage

Perfect

capital markets Perfect information and rationality Business risk is equal The dividend payout ratio is 100 per cent There are no taxes

Provide behavioral justification for a constant ko over the entire range of financial leverage possibilities. Total risk for all security holders of the firm is not altered by the capital structure. Therefore, the total value of the firm is not altered by the firms financing mix.

Market value of debt (35%) Market value of equity (65%) Total firm market value (100%)

Market value of debt (65%) Market value of equity (35%) Total firm market value (100%)

Total market value is not altered by the capital structure (the total size of the pies are the same).

Two firms that are alike in every respect EXCEPT capital structure MUST have the same market value. Otherwise, arbitrage is possible.

Arbitrage Finding two assets that are essentially the same and buying the cheaper and selling the more expensive.

Arbitrage ExampleConsider two firms that are identical in every respect EXCEPT: Company NL no financial leverage Company L $30,000 of 12% debt Market value of debt for Company L equals its par value Required return on equity Company NL is 15% Company L is 16% NOI for each firm is $10,000

Valuation of Company NLEarnings available to =E =OI common shareholders = $10,000 - $0 = $10,000 Market value = E / ke of equity = $10,000 / 0 .15 = $66,667 Total market value = $66,667 + $0 = $66,667 Overall capitalization rate = 15% Debt-to-equity ratio =0

Valuation of Company LEarnings available to common shareholders =E =OI = $10,000 $3,600 = $6,400 = E / ke = $6,400 / 0.16 = $40,000 = $40,000 + $30,000 = $70,000 = 14.3% = 0.75

Market value of equityTotal market value Overall capitalization rate Debt-to-equity ratio

Completing an Arbitrage TransactionAssume you own 1% of the stock of Company L (equity value = $400).You should: 1. Sell the stock in Company L for $400.

2. Borrow $300 at 12% interest (equals 1% of debt for Company L).3. Buy 1% of the stock in Company NL for $666.67. This leaves you with $33.33 for other investments ($400 + $300 - $666.67).

Completing an Arbitrage TransactionOriginal return on investment in Company L$400 16% = $64

Return on investment after the transaction $666.67 16% = $100 return on Company NL $300 12% = $36 interest paid $64 net return ($100 $36) AND $33.33 left over. This reduces the required net investment to $366.67 to earn $64.

Summary of the Arbitrage Transaction The investor uses personal rather than corporate financial leverage. The equity share price in Company NL rises based on increased share demand. The equity share price in Company L falls based on selling pressures. Arbitrage continues until total firm values are identical for companies NL and L. Therefore, all capital structures are equally as acceptable.

Separation b/w Investment decisions. Financial decision Rational criterion for investment decisions Maximization of the market value of the firm Measurement of total cost Rate of return on capital invested in shares of firms in the same risk class.

The

arbitrage process

Assumption of perfect substitutability of personal/home-made leverage with corporate leverage Arbitrage process Not realistic and purely theoretical no practical relevance