# 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 they will.

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 years.

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 in 1993.

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 leading figure.

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.

**Sources:** Wikipedia; Nobel Prize.org