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.