In Search of a Modigliani-Miller Economy
Sep 1, 2004
The Modigliani-Miller theorem describes conditions under which the value of a firm is independent of its leverage ratio. It is one of the cornerstones of finance. A history of this result along with a modern perspective on its derivation is given in Rubinstein (2003), Journal of Investment Management 1(2). We extend this history by examining the relationship between the Modigliani-Miller theorem and quantitative models of creditrisk. In the first part of the paper, we sort out the role of the Modigliani-Miller theorem and Merton's classical structural model. This material may be familiar to some readers. Subsequently, we explore the relationship between the Modigliani-Miller theorem and 12, which is a hybrid structural-reduced form model based on incomplete information, Goldberg (2004), Risk 17(1), 515-518. The 12 model is not consistant with the Modigliani-Miller theorem. It provides a new way to measure the deviation of real markets from the idealized markets in which the Modigliani-Miller theorem holds.