The Modigliani-Miller Theorem

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Neutrality

• A firm’s investment strategy is totally independent of its liquidity position

Early Keynesians View

• theory contradicts the neutrality

• emphasized two variables as determinants of investment

1. current cash flow

2. a firm’s current holdings of liquid assets

• both of these variables are a measure of funds available to a firm without seeking outside investment

Modigliani and Miller

• theory supports the neutrality

• Modigliani and Miller assume that managers maximize shareholder and that markets are frictionless and competitive

• Investment is independent from a firm’s financial position because under the given assumptions, a firm will simply borrow funds to invest. Therefore, the amount of current cash flow and the current liquidity position of a firm will not affect its investment.

Q-Theory

James Tobin (1969)

• A firm will invest up until the point where the marginal cost of producing a new unit of capital is the same as the value of that unit of capital in the stock market. This value is given by the q-ratio

q-ratio- the market value of a firm’s shares divided by its capital stock

• According to q-theory current profits are simply one component of many which determine the value of q, and therefore plays no special role in determining investment

Testing the Theories

Farrazi, Hubbard, and Petersen (1988)

• as was the case with current consumption, experiments showed that investment depended on both q and current cash flow

Explaining the Deviation

1. The difference in information between managers and investors. For example, it is natural for firms that are credit-constrained to be sensitive to available liquidity.

• Some critic this explanation because there are not many credit-constrained firms, and firms with the least credit-restraint are especially sensitive to cash flow

2. Agency Models- excess sensitivity to current cash flow because of self-interested decisions by managers. Examples of such behaviors include laziness, shirking, herding, and aiming at short term gains at the expense of long term earning.

The Missing Motivation

• A sociological analysis of managers’ decision-making stresses the influence of norms, including the fact that employees and managers “have a concept of their duties of their jobs, and they are frustrated when unable to accomplish them.”

• Managers’ ideas about what they should do in their job affect their decisions.

Fligstein (1990) - illustrates the evolution of management conceptions of duty with respect to mergers in the 20th Century

• Three Stages

1. Production Orientation

2. Sales Orientation

3. Finance Orientation (in accordance with Modigliani and Miller)

Summary

Investment neutrality holds only under very narrow conditions. Keynes view that investment is sensitive to a firms’ liquidity is in agreement with maximizing behavior. This dependence could be due to managerial self-interest, agency theory; or it could be due to managerial conceptions of what they should do.

The Missing Motivations in Macroeconomics | Ricardian Equivalence | Dependence of Consumption on Wealth, not Income | Natural Rate Theory | Rational Expectations