Corporate Finance under the MM TheoremsAuthor(s): M. J. GordonSource: Financial Management, Vol. 18, No. 2 (Summer, 1989), pp. 19-28Published by: Blackwell Publishing on behalf of the Financial Management AssociationInternationalStable URL: http://www.jstor.org/stable/3665890Accessed: 07/05/2010 17:31

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Corporate Finance Under the MM

Theorems

M.J. Gordon

M.J. Gordon is a Professor of Finance and Economics at the University of Toronto, Ontario, Canada.

M The Modigliani-Miller [41, 45] papers on capital structure and dividend policy launched the MM theory of corporate finance. Under this theory, the current value of a corporation is independent of its method of financing, and the corporation undertakes the invest- ment opportunities that maximize its current value. The MM theory is true in the limited sense that there is a set of assumptions from which these propositions follow. Under these assumptions, collectively referred to as perfect capital markets, there are no taxes or transaction costs, and all information is simultaneously available without cost to all market participants. The information includes either the future values of the relevant variables or the parameters of their distribu- tions. MM's important innovation was to establish the

conditions under which the ideal properties of a per- fectly competitive market equilibrium under certainty hold when uncertainty and risk aversion are recog- nized.

Any review of the MM influence on corporate fi- nance would likely agree on the following.

(i) MM soon became and has remained the dominant theory of corporate finance. The literature abounds with restatements of the theory-more general, more simple, or more elegant. Advances in the theory either show how an apparent violation of the theory cannot exist when the full implications of the perfect capital market assumptions are rec- ognized, or they establish modifications in the theory that result when one or more but not all of the assumptions are abandoned.

(ii) The MM assumptions describe an ideal state, and the evidence provides no support for their the- orems. The evidence has shown that the value of a corporation does depend upon its capital structure

I am grateful to the editors of Financial Management for this oppor- tunity to voice my views on the influence of MM over the past thirty years. I benefited from comments on an earlier draft of this paper by Trevor Chamberlain, David Fewings, Lawrence Gould, Yehuda Kahane, Paul Potvin, and Yossi Yagil. I also benefited from the editorial advice of Betty Gordon.

19

20 FINANCIAL MANAGEMENT/SUMMER 1989

and upon its dividend policy and that corporations are not motivated solely by the objective of maxi- mizing current market value.

(iii) Notwithstanding the failure of the assumptions and the theorems, Miller and his followers have at various times found evidence consistent with the original MM theorems.

The celebration of the 30th anniversary of MM with five papers by Miller, Ross, and others in the Fall 1988 Journal of Economic Perspectives characterized the MM era as a period of remarkable progress. However, the questions addressed then have not passed into history. On the contrary, the dividend puzzle described in Black [5] still troubles MM's followers. The capital structure puzzle acknowledged in Myers [48] remains far short of a satisfactory solution. In addition, the present state of the theory on the market for corporate control suggests that we may soon have a paper on the manage- ment objective puzzle.

I have not been a follower of MM. In Gordon and Shapiro [29] and Gordon [20], I embarked on the development of a different theory on the investment and financing of the corporation. There and in sub- sequent work I relied on different and more plausible assumptions and came up with theorems that provide a more satisfactory explanation for the stylized facts of corporate finance. Perhaps a review of the MM theory of corporate finance from my perspective will help resolve the puzzles which continue to plague the litera- ture that takes MM as its foundation and seeks to reconcile the evidence with MM. The desirability of an iconoclastic review of MM may be enhanced by the fact that a paper by Findlay and Williams [19] has been the only other such review in a leading finance journal over the last decade.

I. Capital Structure In a very thorough and informed comment, Durand

[11] demonstrated that MM's proof of their leverage theorem was not the powerful arbitrage proof that they claimed.1 Instead, the theorem requires the question- able assumption that personal leverage is a perfect substitute for corporate leverage. In their reply, MM

partially ackowledged this and went on to say that "the most effective method of testing alternative assumptions is to test their consequences" [46, p. 657].

The test carried out by MM [42] gave rise to several critical comments, among which Gordon [21] estab- lished a fundamental error in their use of a regulated industry for their tests. MM's proof started with the assumption that earnings before interest and taxes, X, is independent of a firm's leverage rate, but that is true only for an unregulated firm. For the regulated utility companies in their sample, the tax advantage of lever- age is transferred to the consumer, so that X declines and the value of the firm, V, is unchanged as leverage increases. Recognizing this makes their finding that V increases with leverage contradict their leverage theorem. Instead, their finding is consistent with the alternative hypothesis that investors prefer corporate to personal leverage.2

The appropriate test of the MM leverage theorem is to ask: with earnings, etc., held constant, does the price of a share fall (or the expected return rise) as leverage rises by about the amount predicted by the MM tax model? Wippern [53] and Brigham and Gordon [9] carried out such tests and found no such variation. Rather, they found that as leverage rises, share price falls by less than the amount predicted by MM. A plausible explanation for their results is that for various reasons, among them the institutional arrangements which limit personal leverage to demand (margin) credit, investors prefer corporate to personal leverage. There has been no subsequent empirical work that rules out preference for corporate leverage as a factor in the relation between capital structure and value.3

The greatest contradiction in the MM theory of corporate finance was revealed by MM themselves.

1In arbitrage the item purchased can be delivered against the sale contract, so than any violation of the law of one price generates a sure

profit. No such delivery is possible under the MM theorem, so that it is no more than another theorem on how investors value different securities.

2MM [43. p. 1295] conceded that "On the whole one might be inclined to conclude that a reasonable approximation to the appropriate valuation formula might lie somewhere between ours and Gordon's."

They then went on to argue that the approximation should be closer to their model. Elton and Gruber [13] reviewed the different inter-

pretations of how the regulatory process might influence the relation between leverage and the value of a firm and its cost of capital.

3MM [45] is the only place where expected return varies with leverage as their theory predicted, but in that test expected return is Y/S and

leverage is DIS, with Y = earnings, D = debt, and S = market value of shares. Notice S is the denominator of both variables. MM aban- doned this test in [42]. Subsequent to the empirical work discussed above, it was recognized that the tax on personal income reduces the

gain from leverage due to the corporate tax. That increases the likelihood that preference for corporate leverage is a factor in the

empirical results that have been obtained.

GORDON/CORPORATE FINANCE UNDER THE MM THEOREMS 21

MM [47] showed that with a corporate income tax and with X given, the value of a corporation increases with its leverage, so that a corporation which maximizes its market value should have the maximum feasible lever- age rate. However, actual leverage rates vary over a wide range and typically fall far short of this maximum, making it quite obvious that either their leverage the- orem is not true or firms do not maximize their market value, or both. The wide gap between the MM theorem on capital structure and reality did not go unnoticed, but it was not confronted in the literature prior to Miller [40].

Before then, Farrar and Selwyn [16] and Arditti, Levy, and Sarnat [2] had shown that with D equal to debt and with rp and rc equal to, respectively, the per- sonal and corporate tax rates on interest income, the gain from leverage is reduced to (rc - rp)D. Miller went on to argue that with personal income taxed at progres- sive rates "the value of a firm in equilibrium will still be independent of its capital structure" [40, p. 262]. If true, the Miller theory would explain the wide variation in leverage rates among firms. However, to me it seemed impossible for the Miller theory to be consistent with the MM theory if the latter were extended to allow the tax regime specified by Miller. I found it most puzzling, therefore, that the relation between Miller [40] and MM [47] was not examined either by Miller or by the subsequent literature that referenced Miller's theory.

My puzzlement compelled me finally to extend the MM theorem on capital structure to incorporate the tax regime explicitly stated in the Miller paper. As described in Gordon [25], I found the clientele effects noted by Kim, Lewellen, and McConnell [34] and others. However, with firms distributed in some way over the range of feasible capital structures, an equilibrium was reached in which the values of firms varied with their leverage rates. Hence, as in the MM tax model, all firms that maximize value are motivated to move toward the maximum feasible leverage rate.4 Some years later, I learned that one could reach Miller's contrary con- clusion by assuming risk neutrality. He had implicitly assumed that the bonds and the shares of a corporation are equivalent and perfect substitutes for each other, except that the interest on the bonds carries the label

"deductible as an expense for tax purposes." I could not at that time imagine that the person who had enlarged the theory of corporate finance to recognize the pres- ence of uncertainty and risk aversion would subse- quently present a theory that not only abandoned this assumption but do so without noting it.5

The subsequent literature has modified the MM theory in order to reach a more plausible accommoda- tion with the stylized facts of capital structure. The consensus reached is that there is an interior optimum for the debt-equity ratio and that this optimum balan- ces the tax-induced gain from leverage against the costs of bankruptcy and agency, both of which rise sharply once the leverage rate passes some value.6 See, for example, Bradley, Jarrell, and Kim [7].

However, the evidence in support of this consensus is far from impressive. What was the motive for debt financing prior to the imposition of the corporate in- come tax? What is the evidence that the present value of bankruptcy and agency costs are large enough to offset the tax and other incentives for debt financing at the very low leverage rates we actually observe? Don't the institutional arrangements which limit personal leverage to demand (margin) loans increase the pref- erence for corporate leverage? To what extent do cor- porate managements subordinate the maximization of market value to the long-run survival of the corpora- tion in their capital structure decisions? Thirty years of preoccupation with the defense of MM has produced a theory of capital structure that leaves these and other questions unanswered.

In a presidential address to the American Finance Association, Myers acknowledged that, "We do not know how firms choose the debt, equity or hybrid securities that they issue" [48, p. 575]. Instead of elab- orating on the nature and source of his ignorance, Myers went on to offer two solutions to his capital structure puzzle. One is the vague qualitative consen- sus described above, and the other is a restatement of

4A comment by Jaffe and Westerfield [32] accepted my first con- clusion, and they then showed that my conclusion on the changes in leverage rates by corporation was based on the assumption that the highest personal tax rate is below the corporate rate. See also Gordon [26].

51 first learned this from a footnote to a paper for which I no longer have the reference. For another reference, see the textbook by Ross and Westerfield, who introduce their demonstration of the Miller theorem with the statement, "Now suppose we ignore risk..." [50, p. 368].

6Stiglitz [52] and Rubinstein [51] showed that the MM leverage theory holds with risky debt. However, the theory requires that both bankruptcy and the enforcement of me-first rules are costless. Fama [15] showed that the enforcement of me-first rules poses no problem when the full implications of the perfect capital markets assumptions are recognized.

22 FINANCIAL MANAGEMENT/SUMMER 1989

the traditional "pecking order" theory of capital struc- ture. Firms borrow because debt is less attractive than retained earnings but more attractive than new equity. What are the reasons for this pecking order and how does it result in the range of debt-equity ratios we observe?

Two further questions on the consensus described earlier may be noted. First, how does the value of a firm vary with its leverage rate and what rate maximizes value? This is the central question regarding capital structure, and although econometric methods have been improved greatly, nothing has been done (to my knowl- edge) over the past two decades to advance our empiri- cal knowledge of this question. Why? Second, since the tax benefit from leverage depends not on the corporate tax rate but on its excess over the personal tax rate, the large gain cannot be explained by the tax system alone. What else is at work?

There is now a great interest in using signaling theory to explain financial behavior. With respect to capital structure, it is argued that the use of debt to finance an expansion is taken by the market as a signal that the stock is undervalued, in which case signaling is a source of covariation between leverage and value. This may be true,7 but we still have only a short-run solution to a short-run problem. In the long run, firms should be valued fairly and capital structure should serve other objectives. Otherwise a firm must per- manently maintain the higher leverage rate or, even worse, continuously raise the leverage rate in order to avoid issuing stock and thereby signaling overvalua- tion.

II. Dividend Policy MM [41] argued that the value of a corporation is

independent of its dividend policy. They would be cor- rect if the sale of shares were a perfect substitute for retained earnings in financing investment, and if the repurchase of shares were a perfect substitute for divi- dends in making distributions to shareholders. Both of these conditions would be true under the perfect capi- tal markets assumptions stated at the start of this pa- per. However, we know that capital gains enjoy a more favorable tax treatment than dividends and that the

transaction costs for the issue of shares is higher than for retained earnings. With these departures from MM's perfect capital markets assumptions, the value of a company's stock is maximized (i) when investment is financed through retained earnings rather than through the sale of shares, and (ii) when distributions to share- holders are made through the repurchase of shares rather than through the payment of dividends. For those who accept the MM theorem on dividend policy as being true in the absence of taxes and transaction costs, the widespread practice of paying dividends re- sults in the "dividend puzzle" described by Black [5] (which will be discussed later).

MM [42] tested their dividend policy theorem as well as their leverage theorem. For the former test, they seemed to acknowledge that there is covariation be- tween the dividend and value; reconciliation with their theory was accomplished by abandoning their perfect capital markets assumption that all participants in the market have equal information. They argued that the covariation is due not to the dividend per se but to the information about earnings that management conveys through its dividend. Accordingly, they carried out two regressions of value on variables they called "earnings" and "dividend policy." One was a simple regression, and the other was a two-stage regression in which the earnings figure was changed to incorporate informa- tion on earnings contained in the dividend, and the dividend policy figure was purged of the information.

The test results presented in MM [42, Table 5, p. 369] reveal that the earnings coefficient was over thirty times its standard error in each of the three years used in their tests, and these results were practically identi- cal both with and without the dividend information. Without removal of its information content, the divi- dend policy coefficient was positive in all three years, but it was significantly different from zero in only one year. With removal, it became negative, but also not significantly different from zero. Notwithstanding the fact that the earnings coefficients were unchanged and the dividend coefficients were effectively zero in both regressions, MM took the change in sign as evidence in support of their theory.8

7Here, as with many other applications of information economics, there is a conflicting story that is no less plausible. Instead of being a

signal that the stock is overvalued, a new issue may be a signal that the firm is so loaded with exceptionally profitable investment oppor- tunities that they cannot be financed with retained earnings plus the debt that maintains the existing capital structure.

8They went on to acknowledge that the lack of statistical significance for the dividend policy coefficients cast doubt on their claim that dividend policy influences value through its information on earnings. But they then claimed that the high significance for the earnings coefficients and the lack of significance for the dividend coefficients was evidence that dividend policy has no influence on share price. Of course, the weight of prior and subsequent empirical research sup- ports the opposite conclusion.

GORDON/CORPORATE FINANCE UNDER THE MM THEOREMS 23

The MM theorem that the value of a firm is inde- pendent of its dividend policy implies that the expected return on a share is independent of its distribution between dividend yield and growth. Brigham and Gor- don [9] tested this implication through cross-section regressions of dividend yield on growth leverage and other variables. The growth coefficient was so much larger than minus one (the value predicted by MM) that strong reason was provided for believing that the risk of growth makes the expected return decline as the fraction of earnings paid in dividends rises.9

That is where the matter stood empirically until Black and Scholes [6] presented a new test of the MM theorem. They claimed that the data are consistent with MM, if a regression of expected return on beta and dividend yield result in a coefficient of about zero on the dividend yield. They found that result by means of a new, massive, and complex econometric formulation of the problem, one that took advantage of the meth- odology developed at Chicago for testing the CAPM. This methodology takes as the expected return an av- erage of the realized holding period return over a prior time period. The absence of correlation with the divi- dend yield that they found is consistent with three alternative propositions: (i) the MM assumptions are true; (ii) the covariation in expected return and divi- dend yield due to the tax system is offset by the inverse variation due to the risk of growth; and (iii) the noise in their measurement of the variables and their for- mulation of the problem simply resulted in no correla- tion.

Litzenberger and Ramaswamy [37] found significant positive correlation between expected return and divi- dend yield. Under their methodology, the dividend yield is the dividend paid divided by the price in the ex-dividend months, but it is zero in the months that a share does not go ex-dividend. Hence, their results confirmed the Elton- Gruber [12] finding that a share's price falls by less than the full amount of the dividend when it goes ex-dividend. However, this result tells us absolutely nothing about what happens to a share's expected return when dividend policy changes, that is, when there is a change in the fraction of long-run earnings paid in dividends.

Miller and Scholes [44] and Litzenberger and Rama- swamy [38] engaged in a spirited controversy on the interpretation of the covariation in average holding- period return and dividend yield that was found in all of the cited empirical work except Black-Scholes [6]. What this debate and the empirical work cited failed to recognize is that a positive coefficient on the dividend yield is consistent with an inverse correlation between expected return and dividend yield. Fewings [18] showed that under plausible assumptions growth is risky, in which case beta and dividend yield would be inversely correlated. He found positive correlation between beta and growth, and Hochman [31], among others, found negative correlation between beta and dividend yield. Hence, depending on the relative importance of the tax and risk effects, the positive coefficient on the dividend yield may be more than offset by the product of the positive coefficient on beta and the change in beta with the dividend yield. See also Gordon [27, pp. 86-88].

There has been a considerable body of empirical research to determine if the change in price with a dividend change does or does not take place apart from any change due to earnings announcements. The pre- sumption behind this literature is that the favorable conclusion supported by the data confirms the MM hypothesis that covariation between dividend and price is not due to the dividend per se but to the information in the dividend about earnings. But what is the distinc- tion between a variable and the information it conveys, when the past is of interest only for the information it conveys about the future? Furthermore, I fail to see why a change in the dividend does not simply convey information about a change in future dividends. Of course, an unexpected rise in the dividend conveys information that future earnings as well as dividends will be higher than previously expected, unless a change in the payout rate is also expected. Dividend policy is payout policy, so that this line of reasoning and empiri- cal work in which the payout rate is not among the variables that explain share value has no relevance for the MM theorem on dividend policy.10

Returning to the question of why corporations pay dividends, the answer lies in a simpler, more reasonable interpretation than MM's of the information conveyed

9The very large and statistically significant amount by which the

growth coefficient was above minus one means that the expected return (the sum of the dividend yield and expected growth) varies inversely with the dividend yield. More extensive and direct tests were carried out in Gordon [22, Ch. 6], and these tests also provided absolutely no basis for accepting the MM theorem on dividend policy.

loAssume that a firm has a large and unexpected rise in the dividend and that this rise results in the same percentage increase in both

expected future dividends and earnings. What meaning is there in the statement that the rise in the current stock price is due not to the rise in the dividend per se but to the information that it conveys about the rise in earnings?

24 FINANCIAL MANAGEMENT/SUMMER 1989

by the dividend. Without question, the value of a share is the present value of its expected future payments. These payments are the dividends and share repur- chases expected for each of n periods plus the expected price at the end of the n periods. The latter depends on the payment expectation beyond the n periods, and the conditions under which share repurchases take place cause them to convey little or no information about future repurchases. It follows that corporations pay dividends for the plain and simple reason that the dividend record is a very important source of informa- tion on future dividends, and the current price depends on the expectation of future dividends, not just on payments in general.

The massive evidence that share price is not inde- pendent of dividend policy persuaded me to go beyond testing whether or not the MM theorem is true and to ask instead how investors value shares. Since price depends in fact on expected future dividends, the prob- lem is to arrive at a representation of the expectation that is plausible and makes use of history. Gordon and Gould [28] presented a solution to the problem that is of interest for the following reasons. First, our model implicitly assumed that a firm's investment opportu- nities, unlike those available to a portfolio investor, depend upon the firm's past history. To withdraw that assumption would imply that all persons and firms have the same investment opportunities, in which case the value of a firm would be independent of its investment decision as well as independent of its financing. In such an ideal world, investment as well as financing policy would not matter on the level of the firm. Second, in our model growth is risky from the shareholder's view- point, so that the cost of capital is an increasing func- tion of the growth rate in capital. Finally, all the conclusions reached previously with retained earnings as the sole source of equity funds were shown to hold if the firm is also represented as being expected to issue or repur- chase shares at some rate per annum. Hence, our model also explains how share price varies with a firm's equity financing on that distant planet where dividends and share repurchases are perfect substitutes.

The treatment of our model in the literature is of some interest. Brennan [8] argued that the model con- fused dividend policy with investment policy on the grounds that it assumes retention is the sole source of equity funds. He ignored the fact that new shares are rarely used as a source of funds and then only to sup- plement retained earnings, so that in practice dividend policy is investment policy. He also ignored the fact

that as early as Gordon [20] the model was generalized to include both sources of equity funds.

Perhaps to give an empirical basis for the Brennan thesis, Fama [14, p. 317] claimed to have found that:

"Whatever imperfections are present in the capital market are not sufficient to cause our data to reject the hypothesis that there is a rather complete degree of independence between the dividend and invest- ment decisions offirms. "

What Fama actually found was no correlation in year- to-year movement between the dividends and invest- ment of firms. However, for his data to be evidence of the MM theory on dividend policy, there must also be independence between investment and retained earn- ings-since MM claims that firms are indifferent as to the source of funds used to finance investment. To test this hypothesis, Gordon [23] examined the year-to-year movement in investment and retained earnings for a large sample of firms. The data, of course, revealed very high correlation between these variables. It also re- vealed that the sale of shares was a material source of funds only for exceptionally profitable firms, and for them it was a compliment to and not a substitute for retained earnings. The explanation for Fama's finding is the well-known fact, first noted by Lintner [36], that the information in the dividend persuades corpora- tions to make their dividends independent of the year- to-year fluctuations in earnings and investment. Further evidence that investment is correlated with internal funds is presented in a recent study by Fazzari, Hub- bard, and Petersen [17].

Before proceeding, it may be noted that the litera- ture on dividend policy has considered other topics in information economics and other market imperfec- tions. For a review of this literature, see Ang [1] and the references cited there.

III. Corporate Objectives The MM theory of corporate finance claims not only

that the current market value of a firm is independent of the method of financing, but also that the firm's sole objective is to maximize that value. This maximization serves those shareholders who hold well-diversified portfolios, but the problems of agency caused by asym- metric information give the firm's management con- siderable latitude in pursuing its own interests. This latitude was first recognized over a half century ago by Berle and Means [4]. However, its influence on the

GORDON/CORPORATE FINANCE UNDER THE MM THEOREMS 25

finance literature was at most marginal prior to papers by Ross [49] and by Jensen and Meckling [33].

The latter paper extended the MM theory to recog- nize the consequences of agency under asymmetric information when the corporation has both inside share- holders (who have some measure of control) and out- side shareholders (who are passive portfolio investors). It assumed that both types of shareholders want the corporation to make the decisions that maximize the current market value of their respective net worths. However, the net worth of the insiders includes, in addition to the value of their shares, the present value of the benefits they can extract from the corporation by virtue of their control position. Perquisites is the term used to refer to those benefits that are beyond what the insiders rightfully earn and are obtained at a cost to the shareholders as a whole. Jensen and Meckling [33] have enlarged our understanding of how agency and asym- metric information may influence the terms and valua- tion of corporate securities. However, with respect to the fundamental questions of corporate behavior and valuation, all they did was extend the MM theory to incorporate the taking of perquisites by insiders.

The importance of perquisites should not be over- stated. The large, publicly traded, and management controlled corporation has come to occupy a dominant place in the American economy, a development which would have been impossible if the taking of such per- quisites had not been brought within reasonable limits or been made to take forms that are socially construc- tive. A far better understanding of the investment and financing behavior of management controlled corpora- tions can be obtained by going beyond the work done by Jensen and Meckling on the subject."1 Recall that portfolio investors want the corporation to maximize current market value without regard for what this might do to the probability of bankruptcy one or more peri- ods hence. The reason is that transactions on personal account allow a portfolio investor to make her prob- ability of bankruptcy independent of the probability for each and every corporation in her portfolio. The same is not true of a corporation's management or of its inside shareholders. Their human and/or share capital

can be and are diversified to only a very limited degree. Hence, the present value of their future income, and even more so the utility of that future income, are reduced as the probability of bankruptcy for the cor- poration increases. In addition, the present value and utility of their future income increase with the corpo- ration's expected growth rate for two reasons. First, management's opportunities for promotion increase with the corporation's growth. Second, as shown in Gordon [24], growth reduces the probability of bank- ruptcy so that growth and risk are inversely correlated, the opposite of what is true in the pricing of shares.

The above considerations suggest that a manage- ment's self-interest is served by an investment and financing policy that maximizes the probability of long- run growth and survival for the corporation. That ob- jective would lead management to pay no dividends and adopt a very conservative debt-equity ratio. However, the threat of a hostile takeover of the corporation increases with the shortfall in the actual price of the stock from the maximum feasible price. Hence, the financial policies actually followed are a compromise between value maximization and avoidance of a hostile takeover. Where the compromise is reached depends upon how favorable the legal and institutional environ- ment is for such takeovers. Chamberlain and Gordon [10] formulated an investment model that captures management's concern for long-run growth and sur- vival and found the evidence consistent with that con- cern.

To the degree that a management does not feel threatened by a hostile takeover, its investment and financing policies depart from the objective of value maximization. In particular, the firm will pay a lower dividend and have a higher rate of growth in tangible and intangible (research, development, advertising, etc.) capital than it would under value maximization. This departure from value maximization would be ineffi- cient if all markets were perfectly competitive. They are not. In particular, there is very strong evidence that management compensation is not sensitive to perfor- mance, either of the individual or of the firm. See Medoff and Abraham [39], Lawler [35], and Baker, Jensen, and Murphy [3]. It would seem, therefore, that the promotions and job security that accompany growth figure prominently in the way management shares in the returns from its outstanding performance. Elimi- nating these rewards may be more costly than allowing profitable corporations to overinvest. In other words, using a lower discount rate in its investment decisions

11"Jensen and Meckling acknowledged that their analysis left un- answered many important questions. In particular, "One of the most serious limitation [sic] of the analysis is that as it stands we have not worked out in this paper its application to the very large modern corporation whose managers own little or no equity" [33, p. 356].

26 FINANCIAL MANAGEMENT/SUMMER 1989

than the market provides may be the most important "perquisite" that managements enjoy in the corpora- tions they control.

IV. Conclusion Consideration of the MM theory of corporate fi-

nance in the previous sections has been devoted to

examining each of its three major propositions. In this conclusion, the focus will move on to the broader

perspective of considering the adequacy of the theory as a whole for explaining and influencing the historical

development of finance. Recall that the core of the

theory is a system with perfect capital markets, where

perfection means no taxes, no transaction costs, and all information available to all market participants with- out cost. Actual financial systems fall short of this ideal, more or less, but that should be no basis for rejecting the theory. Its validity should turn on whether or not

progress toward perfect markets is the basis for under-

standing the development of financial systems. If it is, then my only difference with MM would be on how far we still have to go to establish perfect markets--a petty issue compared to their accomplishment in determin-

ing the ideal consequences of perfect markets and in

leading the crusade for eliminating the barriers to their realization.

My problem with the MM theory of corporate fi- nance is the strong implication that perfect capital markets would have for the financial and nonfinancial

corporations through which actual financial systems function. If capital markets were perfect, these or-

ganizations would be no more than legal fictions, in that they would have no purpose beyond serving their shareholders. The relation between a corporation and its shareholders would be like the relation between a

proprietorship and its proprietor--in neither case would the company have a purpose beyond that of its own-

er(s). Insofar as corporations fell short of being legal fictions, they would be barriers to the realization of

perfect capital markets. To elaborate, a brief historical review follows.

Finance involves many things, but the central task, I believe, is the transfer of savings from persons and firms with inferior investment opportunities to those with superior opportunities. Arrangements for these transfers were quite unsatisfactory when capitalist meth- ods for organizing economic activity first appeared during the Middle Ages. At that time, for instance, lending at interest was prohibited by the Church. That and other artificial barriers to perfect capital markets

have been removed over the past five hundred years. For the most part, however, the transaction, informa- tion, agency, and other costs of lending and borrowing have been brought to their current very low levels by the development of a great complex of financial institu- tions. The term financial institutions, as used here, includes not only organizations such as banks and in- surance companies, but also their personnel, institu- tional knowledge, and acceptance in society.

Consider also what has happened to nonfinancial business firms. Two hundred years ago they were either

proprietorships or partnerships, with a few crown cor-

porations created to exploit monopoly privileges. To-

day, the business sector in advanced capitalist countries is dominated by large corporations that are publicly traded, professionally managed, and owned by passive investors. The institutional developments that made this transformation possible have replaced the prohibi- tive agency costs of equity investment incurred by the

partners with the modest costs incurred by portfolio stockholders, who typically have no direct knowledge of the corporations they own.

It seems to me that there is something fundamental-

ly wrong with a theory that reduces our great financial and nonfinancial corporations to legal fictions at best, and at worst, to barriers for the realization of perfect capital markets. Modern corporations may not have the power of government over the welfare of society, but their collective impact is enormous. In some quar- ters, they are called supranational organizations, and the consequences of their increasing power for good or for evil are hotly debated. What this means is that for a theory of corporate finance to explain and advance

practice and guide public policy it must go beyond reducing these great institutions to legal fictions. They are not leal fictions because (i) their investment oppor- tunities depend significantly on their prior history; (ii) the welfare of their management, workers, communi- ties, and of society-at-large (if not of their portfolio investors) is tied to their future success; and (iii) their future success depends materially on their past and

present investment and financing policies. Thus, the

reality of the modern corporation raises questions for both private and public policy that cannot be com- prehended with the framework of the MM theory of corporate finance.

Under that theory, hostile takeovers and leveraged buyouts make capital markets more perfect. They are instruments by which the "market for corporate con- trol" eliminates management barriers to the realiza-

GORDON/CORPORATE FINANCE UNDER THE MM THEOREMS 27

tion of perfect capital markets. However, few of our political leaders and corporate executives look on cor- porations as legal fictions, and their ranks are being joined by an increasing number of economists. An article on the RJR Nabisco leveraged buyout by John Greenwald [30] in Time quoted John Creedon, presi- dent of Metropolitan Life, as saying, "What is being done threatens the very basis of our capitalist system." Of even more interest here, the article then quoted a leading economist as saying:

"High leverage is unsafe, not just for a company but the entire economy.....LBOs are reducing the safety. Management loses the power to do many things. It has no margin for error and less margin for addition- al risk. "

The author of this statement is Franco Modigliani!

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28 FINANCIAL MANAGEMENT/SUMMER 1989

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CALL FOR PARTICIPA TIONAND PROPOSALS

The Midsouth Academy of Economics and Finance invites you to participate in the 17th annual meeting in Jackson, MS, February 7-10, 1990. Our 1989 meeting in Nashville, TN attracted nearly 300 participants from over 25 states and several nations. Most topics in economics and finance are acceptable. Prior to October 10, 1989, send the following material to the General Program Coordinator: a completed Program Participation form (available from the Program Coordinator); a title

page containing the title of the paper, the author(s)' s name(s), and professional affiliation(s); a 500-word abstract; and a

copy of the paper, if completed. Send to:

Ty Black, MAEF General Program Coordinator College of Business Administration University of Southern Mississippi

Southern Station, Box 5021 Hattiesburg, MS 39406-5021

Papers and comments presented by registrants can be published in the proceedings of the annual meeting, provided that the final copy meets the standards and deadlines established by the editor. Alternatively, papers presented at the annual meeting, as well as other manuscripts, may be submitted for review in the refereed section of the Journal of Economics and Finance, a publication of the Midsouth Academy of Economics and Finance, Memphis State University and Mississippi State University.