Modigliani-Miller On Capital Structure: A Post-Keynesian Critique

Abstract

The celebrated Modigliani-Miller (hereafter MM) proposition that the value of the firm depends on its profitability and not on its capital structure (Modigliani and Miller 1958) is avowedly an application to the field of finance of the doctrine that money is neutral. The broad purpose of this paper is to call into question the claim for the neutrality of money in the particular case of the money-contract relationship represented by corporate gearing, 1 by invoking essentially the same argument as post-Keynesians use to dispute it in the general macroeconomic case: that, in a monetary production economy operating under conditions of intractable uncertainty and in which firms and households constitute categorically distinct functional entities, money and money contracts have a unique and positive role. Orthodox capital structure theorists divide into two camps. 2 The fundamentalists, specifically MM themselves, argue that the world approaches perfection sufficiently closely, or that imperfections are mutually offsetting to a sufficient degree, for gearing not to matter in reality. 3 The revisionists, including authors of finance texts writing for a wide readership for whom theoretical ingenuity may not necessarily be the highest value, attempt to accommodate, within the confines of orthodoxy, what Edwards (1987 p.1) describes as (t)he stark contrast between Modigliani and Miller's theoretical analysis and empirical observations of the importance attached to capital structure... by both firms and investors. In essence, their argument is that imperfections are important enough to make gearing matter, that they are in fact the key to understanding why firms make the gearing decisions they do. This paper takes issue with fundamentalist and 1 or leverage in US parlance 2 This statement is perhaps in need of some qualification, since it is not clear that the group of theorists who seek to explain capital structure outcomes in terms of information asymmetries can straightforwardly be classified as belonging to either camp. [For a sympathetic survey of such views, see Edwards (1987)]. To undertake a full critique of this approach within this paper would be too much of a digression from its central purpose. Suffice it to say that these writers seem to have discovered facts about agents' consciousness - that gearing decisions have information content - of which, on all the empirical evidence available, the agents in question, corporate managers and stock market traders, seem blissfully unaware. 3 This is the essence of the argument to be found in Miller (1977), in which he seeks to vindicate the original MM position against the view which he sees as having subsequently become dominant and which I label revisionist.