Merton Howard Miller
(1923 - 2000)
Merton Howard Miller was born in Boston, Massachusetts.
He worked during World War II as an economist in the division of tax research of the Treasury Department,
and received a Ph.D. in economics from Johns Hopkins University, 1952.
In 1958, he collaborated with Franco Modigliani to
write a paper on The Cost of Capital, Corporate Finance and the
Theory of Investment. This paper urged a fundamental objection
to the traditional view of corporate finance, according to which a corporation
can reduce its cost of capital by finding the right debt-to-equity ratio.
According to Miller-Modigliani, on the other hand, there is no right
ratio, so corporate managers should seek to minimize tax liability and
maximize corporate net wealth, letting the debt ratio chips fall where
The way in which they arrived at this conclusion made
use of the "no arbitrage" argument, i.e. the premise that
any state of affairs that will allow traders of any market instrument
to create a riskless money machine will almost immediately disappear.
They set the pattern for many arguments based on that premise in subsequent
Miller wrote or co-authored eight books. He was a made
a fellow of the Econometric Society in 1975 and was president of the
American Finance Association in 1976. He was on the faculty of the University
of Chicago Graduate School of Business from 1961 until his retirement
He served as a public director on the Chicago Board
of Trade 1983-85 and the Chicago Mercantile Exchange from 1990 until
his death, in Chicago.
Miller won the Nobel Prize in Economics in 1990, along
with Harry Markowitz and William Sharpe. The following press release
from the Royal Swedish Academy of Sciences describes Miller's work:
Merton Miller - initially in collaboration with Franco
Modigliani - established a theory for the relation, via the capital
market, between the capital asset structure and dividend policy of
production firms on one hand and firms' market value and costs of
capital on the other.
The theory is based on the assumption that stockholders
themselves have access to the same capital market as arms. This implies
that within the limits of their asset portfolios, investors themselves
can find their own balance between returns and risk. As a result,
firms do not have to adjust their decisions to different stockholders'
risk preferences. Corporate managers can best safeguard the interests
of stockholders simply by maximizmg the firm's net wealth. In other
words, it is not in the investors' interest that firms reduce risks
through diversification, as the stockholders can accomplish this themselves
through their own portfolio choice.
The basic model was formulated in Miller's and Modigliani's
essay entitled "The Cost of Capital, Corporation Finance and
the Theory of Investment" (1958); it was followed by two other
important essays in 1963 and 1966. Using this basic model, Miller
and Modigliani derived two so-called invariance theorems, now known
as the MM theorems.
The first invariance theorem states that (i) the
choice between equity financing and borrowing does not affect a firm's
market value and average costs of capital, and (ii) the expected return
on a firm's shares (and hence the cost of equity capital) increases
linearly with the ratio between the firm's liabilities and equity,
i.e., the well-known leverage effect. The second invariance theorem
states that under the same assumptions, a firm's dividend policy does
not affect its market value.
In retrospect, the intuition underlying the MM theorems
appears simple. The effects of every change in a firm's financial
asset structure on the stockholders' portfolios can be "counteracted"
by changes in the stockholders' own portfolios. Investors are quite
simply not prepared to "pay extra" for an "indirect"
loan from a firm which increases its borrowing when the investor himself
can borrow on equal terms on the market.
The intuition behind MM's second invariance theorem,
i.e., that dividend policy does not affect the market value of the
firm in equilibrium, is also apparent in retrospect. An additional
dollar in dividends lowers the net wealth of the firm by one dollar
which, in efficient stock markets, implies that the stockholders'
units are worth one dollar less. This relation is not quite as simple
as it seems. As in the case of the first invariance theorem, the mechanism
which generates this conclusion is that investors in the capital market
can "counteract" changes in firms' financial structure.
Both of the invariance theorems were originally derived
under highly simplified assumptions. Therefore, subsequent research
has to a large extent dealt with the consequences of various deviations
from the conditions on which the MM theorems were based. This research
has been in progress since the mid-1960s, with Merton Miller as its
Miller thus showed how the design of different tax
structures affects the relation between firms' capital asset structure
and market value, after taking into account the indirect market effects
of taxes through equilibrium price formation on financial markets.
Similarly, Miller analyzed the importance of bankruptcy costs for
the relation between a firm's financial asset structure and dividend
policy on one hand and its stock-market value on the other.
The main message of the MM theorems may be expressed
as follows: if there is an optimal capital asset structure and dividend
policy for firms, i.e., if the asset structure and dividend policy
affect a firm's market value, then this reflects the consequences
of taxes or other explicitly identified market imperfections. The
MM theorems have therefore become the natural basis, or norm of comparison
for theoretical and empirical analysis in corporate finance. Merton
Miller is the researcher who has dominated this analysis during the
last two decades. He has thus made a unique contribution to modern
theory of corporate finance.