Why Financial Structure Matters

The 1958 paper by Franco Modigliani and Merton Miller has been justly hailed as a landmark in the modern theory of finance. What has not been sufficiently emphasized is the importance of the paper to the development of economic theory and practice. Indeed, it is ironic that a paper which purportedly established that one need not pay any attention to financial structure—that financial structure was irrelevant—should have focused economists' attention on finance. Merton Miller gives what must be part of the explanation in his preceding paper in this issue: by providing conditions where financial policy was irrelevant, conditions which were close to the assumptions used by most conventional economists, the paper forced a reexamination of those standard assumptions. That reexamination is still going on. The MM results have such great intellectual power and appeal that their direct effect has sometimes been to lead economists astray. This result may perhaps be seen most forcefully in the work in investment theory. In the major study done prior to MM, that of Meyer and Kuh (1959), financial variables (like profitability) were identified as having important independent effects on investment. But the paradigm that became dominant following the publication of MM, most forcefully articulated by Dale Jorgenson and his associates, argues that in the absence of taxation, financial structure (for instance, the magnitude of the firm's equity base) or cash fiow would make no difference to the level of investment. Theory drove the econometrics: financial structure variables were excluded because "economic theory"—that is, Modigliani and Miller—said they should be excluded. Only recently, as a developing and substantial body of economic theory says once again that such variables should be included, have econometricians included profit variables again in their specifications