Earlier Life Of Modigliani:

Franco Modigliani was Italian economist.He was Born in Rome June 18, 1918. At age 17, he enrolled in the University of Rome to pursue a law degree. Modigliani left Italy for Paris to continue studying. In 1939, he briefly returned to the University of Rome to receive his Doctor Juris. 1940: Franco Modigliani started hosting informal seminars. 1941: Modigliani left the New School to take a professorship at New Jersey College for Women.

1942: He joined Columbia University as instructor in economics and statistics. 1944: Franco Modigliani obtained his D. Soc. Sci. from the New School for Social Research.

1946: Franco Modigliani became a U.S citizen. 1948: Franco Modigliani awarded the Political Economy Fellowship of the University of Chicago. 1949: Franco Modiglianis work "Fluctuations in the Saving-Income Ratio: A Problem in Economic Forecasting, published in Studies in Income and Wealth. 1952 to 1960: Modigliani joined the Canegie Institute of Technology. Modigliani, along with Merton Miller, formulated the important ModiglianiMiller theorem in corporate finance and financial markets.

1963: Franco Modiglianis work with Merton Miller "Corporate Income Taxes and the Cost of Capital" was published in American Economic Review. Franco Modigliani was awarded the Nobel Prize for Economics in 1985 for his work in savings the dynamics of financial markets. Franco Modigliani died on September 25, 2003, at the age of 85.

Reaseacher Main Interest

Field of Reasearcher is Financial economics. Financial economics is the branch of economics studying the interrelation of financial variables, such as prices, interest rates and shares, as opposed to those concerning the real economy.

Books Written By Modgilaini

The Debate Over Stabilization Policy published 1986 The Collected Paper volume1: Essays in Macroeconomic published 1989 The Collected Papers of Volume 3: The Theory of Finance and Other Essays published 1989 The Collected Papers of Franco Modigliani published 2005 The European Economic Recovery: A Need for New Policies? Rethinking Pension Reform published 2004 The Debate Over Stabilization Policy published 1986

Books Written With Co-Authur

Foundations of Financial Markets and Institutions published 1901 (first and most popular book Capital Markets: Institutions And Instruments published 1992 Investment Management Published 1995 The Monetarist Controversy: A Seminar Discussion Mortgage and Mortgage-Backed Securities Markets published 1992

Contribution of Modigliani
Developed sub models of private consumption and the financial sector, studied the consequences for household saving of changes in demography and economic growth, and laid the foundation for the field "corporate finance.(contribution toward in field of economics and finance.)

Achievements and Awards

Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions. (for household savingThe life cycle hypothesis modle). MIT's James R. Killian Faculty Achievement Award, 1985 (for lecture deliver in household saving).

Main Reasearch Theories

1-ModiglianiMiller theorem (M&M)
The theorem was first proposed by F. Modigliani and M. Miller in 1958. Franco Modigliani, Merton Miller forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed . It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the ModiglianiMiller theorem is also often called the capital structure irrelevance principle.

(e.g) Consider two firms which are identical except for their financial structures. The first (Firm U) is unlevered: that is, it is financed by equity only. The other (Firm L) is levered: it is financed partly by equity, and partly by debt. The ModiglianiMiller theorem states that the value of the two firms is the same le.

Without taxes
Proposition I: where is the value of an unlevered firm = price of buying a firm composed only of equity, and is the value of a levered firm = price of buying a firm that is composed of some mix of debt and equity. Another word for levered is geared, which has the same meaning. (e.g) Suppose an investor is considering buying one of the two firms U or L. Instead of purchasing the shares of the levered firm L, he could purchase the shares of firm U and borrow the same amount of money B that firm L does. The eventual returns to either of these investments would be the same. Therefore the price of L must be the same as the price of U minus the money borrowed B, which is the value of L's debt. This discussion also clarifies the role of some of the theorem's assumptions. We have implicitly assumed that the investor's cost of borrowing money is the same as that of the firm, which need not be true in the presence of asymmetric information, in the absence of efficient markets, or if the investor has a different risk profile to the firm.

Proposition II:.

Proposition II with risky debt. As leverage (D/E) increases, the WACC (k0) stays constant.

is the required rate of return on equity, or cost of equity. is the company unlevered cost of capital (ie assume no leverage). is the required rate of return on borrowings, or cost of debt. is the debt-to-equity ratio.

A higher debt-to-equity ratio leads to a higher required return on equity, because of the higher risk involved for equity-holders in a company with debt. The formula is derived from the theory of weighted average cost of capital (WACC). These propositions are true assuming the following assumptions:

no transaction costs exist, and individuals and corporations borrow at the same rates.

That is, capital structure matters precisely because one or more of these assumptions is violated. It tells where to look for determinants of optimal capital structure and how those factors might affect optimal capital structure.

With taxes
Proposition I:

where

is the value of a levered firm. is the value of an unlevered firm. is the tax rate ( ) x the value of debt (D) the term assumes debt is perpetual

This means that there are advantages for firms to be levered, since corporations can deduct interest payments. Therefore leverage lowers tax payments. Dividend payments are non-deductible. Proposition II:

where

is the required rate of return on equity, or cost of levered equity = unlevered equity + financing premium. is the company cost of equity capital with no leverage (unlevered cost of equity, or return on assets with D/E = 0). is the required rate of return on borrowings, or cost of debt. is the debt-to-equity ratio. is the tax rate.

The same relationship as earlier described stating that the cost of equity rises with leverage, because the risk to equity rises, still holds. The formula however has implications for the difference with the WACC. Their second attempt on capital structure included taxes has identified that as the level of gearing increases by replacing equity with cheap debt the level of the WACC drops and an optimal capital structure does indeed exist at a point where debt is 100%

The following assumptions are made in the propositions with taxes:

corporations are taxed at the rate on earnings after interest, no transaction costs exist, and individuals and corporations borrow at the same rate

Important implications for the M&M

1. One is that such decisions can be separated from the corresponding financial decision. 2. Another implication is that the rational criterion for investment decisions is a maximization of the market value of the firm. 3. Third is that the rational concept of capital cost refer to total cost,and should be measured as the rate of return on capital invested in shares of firms in the same risk class.

2-The Life Cycle Hypothesis

In the early 1950s, Franco Modigliani and his student, Richard Brumberg, developed a theory based on the observation that people make consumption decisions based on the resources available to them over their lifetime and which stage of life they are currently at. They had observed that individuals build up assets at the initial stages of their working lives. Later on during retirement, they make use of their stock of assets. The working people save up for their post-retirement lives and alter their consumption patterns according to their needs at different stages of their lives. The Life Cycle Hypothesis (LCH) is an economic concept analysing individual consumption patterns. The life-cycle hypothesis considers that individuals plan their consumption and savings behaviour over the long term and intend to even out their consumption in the best possible manner over their entire lifetimes.

Hypothesis Develop
Assume that there is a consumer who expects that he will live for another T years and has wealth of W. The consumer also expects to earn income Y

until he retires R years from now. In this situation the consumer's resources over his lifetime consists of his initial endowment of wealth, W, and his lifetime earnings of RY. It has to be added that we are assuming that the interest rate is zero. If the interest rate were positive, we would have to account for the interest earned on savings. The consumer can distribute his lifetime resources over the remaining T years of his life. He divides W + RY equally among T years and in each year he consumes

The consumption function of this person can be written as

If every individual in the economy plans his consumption in this manner, then the aggregate consumption function will be quite similar to the individual one. Thus, the aggregate consumption function of the economy is

where a is the marginal propensity to consume out of wealth and b is the marginal propensity to consume out of income.

Implications
From the equation given above, it is clear that if the income falls to zero the amount of consumption will be equal to aW. However, this is not a fixed value, as it depends on wealth. Moreover, according to the given consumption function, the average propensity to consume is

Since wealth does not change proportionately with income from individual to individual or from year to year, we should get the result that high income

leads to a low average propensity to consume while looking at the data across persons or over short periods of time. However, generally over a long period of time, wealth and income increase together which leads to a constant ratio WY and thus a constant average propensity to consume. In order to further analyse the implications of the life-cycle model we start by considering the case of a stationary economy in which population and productivity are constant through time. Then, we relax these assumptions one by one.

Saving and Wealth when Income and Population are stable

if we make some rational guesses about the average duration of working life and retired life and additionally assume that the rate of earning is constant till retirement and so is the rate of consumption combined with a zero rate of return on net worth we can find that in a stationary economy of constant population and productivity, the aggregate stock of wealth would be very significant. Moreover, under the given conditions, the aggregate rate of saving would become zero as the level of positive saving by the individuals during their earning years would be offset by the dissaving of the retired households using up their earlier accumulation. Hence, wealth will remain constant in totality even though it is constantly being transferred from dissavers to savers in exchange for current resources. The Effect of Population Growth Let us assume that income grows as a consequence of population growth or due to growth in income per employed which is itself a consequence of increasing productivity. We can then prove that saving will be positive even if there are no bequests. We initially analyse the effect of pure population growth while keeping all other assumptions the same. If the size of the cohorts born in successive years grows at the rate p then both population and the aggregate income will grow at the rate p. As a result of this growth there will be an increase in the ratio of younger individuals in their earning phase to retired individuals in their dissaving phase, leading to a positive net flow of saving. It can also be seen that if the rate of growth of population is constant in time then aggregate saving and wealth will also increase at the rate p and hence will be proportional to aggregate income.

 The Effect of Productivity Growth We now consider the situation where population is stationary but average income earned at each age, and hence, aggregate income rises continuously over time due to increasing productivity. This will also have a tendency to lead to a positive rate of saving and a growing stock of wealth. This is due to fact that each successive cohort will enjoy earning greater than the preceding cohorts, and thus a large level of consumption at each age, since by assumption the allocation of consumption over life remains unchanged in time. Moreover this implies that the currently working generation will aim for a level of consumption in their post-retirement years larger than the consumption enjoyed by the currently retired individuals belonging to a less affluent generation. In order to support this future level of consumption post-retirement, the working individuals will have to save currently on a scale higher than the dissaving of the retired households. Hence even if population is stationary net aggregate saving will have a tendency to be positive.

Theory and Evidence

The findings of many economists bring out a problem in the life-cycle model. There are two explanations for the aforementioned behaviour of the elderly. The first explanation is that the retired individuals are cautious about unpredictable expenses. The additional saving that arises due to this behaviour is called precautionary saving. Precautionary saving may be made for the probable event of living longer than expected and hence having to provide for a longer than the planned span of retirement. Another rational reason is possibility of ill-health and huge medical expenses. These probable events make the elderly save more. The second explanation is that the elderly may save more in order to leave bequests to their children. This will discourage dissaving at the expected rate.