The Modigliani-Miller Theorem

---

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

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