Modigliani and Miller: The Informal Way

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Are you looking forward to understand the various ideas associated with the firms a lot better? Well, if you are, it is strongly recommended for you to go through the various propositions of M & M, namely Modigliani Miller. It will without a doubt give the readers a firm idea as far as the various decisions related to the capital structure are concerned. However, if you are actually willing to learn this theory, it is important for you to be well aware of the various rules of algebraic operations as it mostly comprises of such operations. Though this may appear to be quite complex, they ideas on which they are based are quite simple and easy to understand. These ideas ought to be explained with the help of the anecdote that follows. Merton Miller had given a welcome speech for Louvain in 1986 in Belgium. This anecdote was a major attraction as far as his speech was concerned. His other half had already received a noble prize and he himself would receive the same in the years to follow.

When Franco Modigliani my other half as far as the book goes received a noble prize in October, these papers came to my table. He has received the prize in the field of economics. The idea itself seemed to be complex, summarizing these papers and explaining them did not appear to be that easy. I was immediately approached by the media of Chicago. They asked me to explain these papers in front of the public through their channel in brief. On being asked how brief do they want the explanation to be, to my disdain they replied about ten seconds. Our work majorly comprised of two articles each having about a thirty pages. In addition to this, each page had footnotes that were about 60 words longs. This was something that two of us had dedicated our lives to. The idea of explaining all of that in a matter of ten seconds sounded quite absurd. On realizing my disdain, they asked me not to explain things in depth. They just wanted an overall idea. The first thing that came to my mind was the capital structure of the 1st article. According to this principle, the risks and the earning capabilities governed the value of the various securities in the market.

Describing all of our work in a single speech would be based on various concepts that would appear to be absurd as far as the common people were concerned. The situation I fell into was quite similar to that of the market of the capitals. These markets are quite efficient as far as economists are concerned. However when it comes to the public, it isn’t. Hence, it appeared to me that the manner of explanation that I was thinking of isn’t going to pay off. Then I thought of bringing in an analogy. I asked the listeners to consider a company or a firm as a huge tub containing milk. I went ahead. The farmer ought to have two options ahead of him. The first to sell the whole thing as it is. The second way however is a bit different, he might as well consider the idea of separating the cream which he could without a doubt sell at a much higher price as compared to the 1st option. Selling cream here is analogous to clearing out the securities of higher debts. However, once the farmer has sold the cream, it is imperative that the milk that is now left with him is exceedingly skim and would certain sell at a much lower price in comparison to the price of the whole milk. The milk that is left over after the cream has been sold is analogous to the equity that has been levered. According to the various propositions that were made in the two articles of M & M, the net value or the net profit in both the cases would be same if you consider that the separation cost was zero. This still appeared to be exceedingly long to the media people and they informed me the same after a while of discussions. They asked for something that would be a lot simpler than what I had just said. Securities are nothing but tool that initiate the division of the pay offs of a particular firm. Another proposition in our articles comprised of these ideas as well as the idea of the market being complete. These partitions were considered to be in accordance with the various possible states. Next I asked how many of them love pizza? I further asked them to assume the entire firm to be a pizza.  This got everyone excited. The pizza was divided into 4 quarters. Now I asked them to further divide each piece in the ratio 1 : 1. According to the various propositions make in our articles, the owner of the pizza will definitely have more number of pieces but does that signify that they will have more pizza? Obviously not!

Even this did not penetrate their brains. After a bit of further discussions, they came up to me again and asked me to move on to two the next proposition in our articles, namely the proposition for invariance. Explaining this proposition within such a short time span was a lot more difficult. Individuals today focus on getting profits divided but in turn they fail to forget that the more the number of individuals among whom the profit must be divided, the lesser will be the individual earning. However, the dividend is something that needs to be earned. It is analogous to the profit a particular firm or company makes. The articles did not focus on these much. According to the proposition, once a firm was functional, the dividend value and the shareholder value isn’t going to be related in any manner. While I was considering all these facts, it struck me. I had only ten seconds to explain all this. Then I thought of another anecdote. Consider a situation where in you have some money in your right hand pocket, say ten dollars. If you transfer the money to the other pocket, the ten dollar certain isn’t going to change.

On hearing this, they again started conversing with one another. However, to my delight, they started packing up. Once they were done with the packing up of their equipment’s they came up to me and thanked me in return for my cooperation. In the end they added that they might just get back to me. However, I felt that my chance for gaining some popularity went away from me. I said to myself that when it comes to explaining lifelong research papers in ten seconds, not everyone can be good at it. Getting back to the examples I went up to, they weren’t actually sufficient as far as doing justice is concerned. Yes, they did have a bit of resemblance but if you consider complete justice, they were lagging way behind. Certain writers even went on with clarifying my first example. He did so by finding out the costs of skim milk, whole milk and cream in various markets.

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