Corporate Finance under the MM Theorems

Author(s): M. J. Gordon
Source: Financial Management, Vol. 18, No. 2 (Summer, 1989), pp. 19-28
Published by: Blackwell Publishing on behalf of the Financial Management Association
International
Stable URL: http://www.jstor.org/stable/3665890
Accessed: 07/05/2010 17:31

Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at
http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless
you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you
may use content in the JSTOR archive only for your personal, non-commercial use.

Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at
http://www.jstor.org/action/showPublisher?publisherCode=black.

Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed
page of such transmission.

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of
content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms
of scholarship. For more information about JSTOR, please contact support@jstor.org.

Financial Management Association International and Blackwell Publishing are collaborating with JSTOR to
digitize, preserve and extend access to Financial Management.

http://www.jstor.org
Corporate Finance Under
Theorems
M.J.Gordon
M.J. Gordon is a Professor of Finance and Economics at the Universityof
Toronto,Ontario, Canada.
M The Modigliani-Miller[41, 45] papers on capital
structureanddividendpolicylaunchedthe MMtheory
of corporatefinance. Under this theory,the current
valueof a corporationis independentof its methodof
financing,and the corporationundertakesthe invest-
ment opportunitiesthat maximizeits currentvalue.
The MM theoryis true in the limitedsense that there
is a set of assumptionsfromwhichthese propositions
follow. Underthese assumptions,collectivelyreferred
to as perfect capital markets,there are no taxes or
transactioncosts,andall informationis simultaneously
availablewithoutcost to all marketparticipants.The
informationincludes either the future values of the
relevantvariablesor the parametersof their distribu-
tions. MM'simportantinnovationwas to establishthe
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
TrevorChamberlain,DavidFewings,LawrenceGould,Yehuda Kahane,
Paul Potvin, and Yossi Yagil. I also benefited from the editorial advice
of Betty Gordon.
19
the MM
conditionsunderwhichthe ideal propertiesof a per-
fectly competitivemarketequilibriumundercertainty
hold when uncertaintyand risk aversion are recog-
nized.
Any reviewof the MM influenceon corporatefi-
nancewouldlikelyagreeon the following.
(i) MMsoon becameandhas remainedthe dominant
theoryof corporatefinance.Theliteratureabounds
with restatementsof the theory-more general,
more simple, or more elegant. Advancesin the
theoryeither show how an apparentviolation of
the theorycannotexistwhen the full implications
of the perfectcapitalmarketassumptionsarerec-
ognized,or theyestablishmodifications
in thetheory
that result when one or more but not all of the
assumptionsare abandoned.
(ii) The MMassumptionsdescribean ideal state,and
the evidence provides no support for their the-
orems.The evidencehas shownthatthe valueof a
corporationdoesdependuponits capitalstructure
20
andupon its dividendpolicyandthatcorporations
are not motivatedsolely by the objectiveof maxi-
mizingcurrentmarketvalue.
(iii) Notwithstandingthe failure of the assumptions
andthe theorems,Millerandhis followershaveat
varioustimes found evidenceconsistentwith the
originalMMtheorems.
The celebrationof the 30th anniversaryof MM with
five papersby Miller,Ross, andothersin the Fall 1988
Journalof EconomicPerspectives characterizedthe MM
era as a periodof remarkableprogress.However,the
questionsaddressedthen havenot passedinto history.
Onthe contrary,the dividendpuzzledescribedin Black
[5] still troublesMM'sfollowers.The capitalstructure
puzzle acknowledgedin Myers[48] remainsfar short
of a satisfactorysolution.In addition,the presentstate
of the theory on the market for corporatecontrol
suggeststhatwe maysoon havea paperon the manage-
mentobjectivepuzzle.
I have not been a followerof MM. In Gordonand
Shapiro [29] and Gordon [20], I embarkedon the
developmentof a differenttheoryon the investment
and financingof the corporation.There and in sub-
sequentworkI relied on differentand more plausible
assumptionsand came up with theoremsthat provide
a moresatisfactoryexplanationfor the stylizedfactsof
corporatefinance.Perhapsa reviewof the MM theory
of corporatefinance from my perspectivewill help
resolvethe puzzleswhichcontinueto plaguethe litera-
ture that takes MM as its foundation and seeks to
reconcilethe evidencewith MM.The desirabilityof an
iconoclasticreviewof MMmaybe enhancedbythe fact
thata paperby FindlayandWilliams[19] hasbeen the
onlyothersuchreviewin a leadingfinancejournalover
the last decade.
I. CapitalStructure
In a verythoroughandinformedcomment,Durand
[11] demonstratedthat MM'sproof of their leverage
theoremwasnot the powerfularbitrageproofthatthey
claimed.1Instead,the theoremrequiresthe question-
able assumptionthat personal leverage is a perfect
substitutefor corporateleverage.In their reply,MM
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.
FINANCIAL 1989
MANAGEMENT/SUMMER
partiallyackowledgedthis andwenton to saythat"the
mosteffectivemethodof testingalternativeassumptions
is to testtheirconsequences" [46,p. 657].
The test carriedout by MM[42]gaverise to several
critical comments,amongwhich Gordon [21] estab-
lished a fundamentalerrorin their use of a regulated
industryfor their tests. MM'sproof startedwith the
assumptionthat earningsbeforeinterestand taxes,X,
is independentof a firm'sleveragerate,but thatis true
only for an unregulatedfirm.For the regulatedutility
companiesin theirsample,the taxadvantageof lever-
age is transferredto the consumer,so thatX declines
and the value of the firm, V,is unchangedas leverage
increases.Recognizingthis makestheirfindingthat V
increaseswithleveragecontradict theirleveragetheorem.
Instead,theirfindingis consistentwith the alternative
hypothesisthat investorsprefercorporateto personal
leverage.2
The appropriatetest of the MMleveragetheoremis
to ask:withearnings,etc., heldconstant,does the price
of a sharefall (or the expectedreturnrise) as leverage
rises by about the amount predictedby the MM tax
model? Wippern [53] and Brighamand Gordon [9]
carriedout such tests and found no such variation.
Rather,they found that as leveragerises, share price
falls by less than the amount predictedby MM. A
plausibleexplanationfortheirresultsis thatforvarious
reasons,among them the institutionalarrangements
whichlimitpersonalleverageto demand(margin)credit,
investorsprefercorporateto personalleverage.There
has been no subsequentempiricalworkthat rulesout
preferencefor corporateleverageas a factor in the
relationbetweencapitalstructureandvalue.3
The greatest contradictionin the MM theory of
corporate finance was revealedby MM themselves.
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 regulatoryprocess 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 returnvaries 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.
 FINANCEUNDERTHEMMTHEOREMS
GORDON/CORPORATE
MM [47]showedthatwith a corporateincometaxand
withX given,the valueof a corporationincreaseswith
its leverage,so that a corporationwhichmaximizesits
marketvalueshouldhavethe maximumfeasiblelever-
age rate. However,actual leveragerates vary over a
widerangeandtypicallyfall farshortof this maximum,
makingit quite obviousthat either their leveragethe-
oremis not trueor firmsdo not maximizetheirmarket
value,or both.Thewidegapbetweenthe MMtheorem
on capitalstructureand realitydid not go unnoticed,
but it was not confrontedin the literatureprior to
Miller[40].
Before then, Farrarand Selwyn [16] and Arditti,
Levy,and Sarnat[2] had shown that with D equal to
debt andwith rpandrc equal to, respectively,the per-
sonal and corporatetax rates on interestincome,the
gainfromleverageis reducedto (rc- rp)D.Miller went
on to arguethatwithpersonalincometaxedat progres-
sive rates "thevalue of a firm in equilibriumwill still
be independentof its capitalstructure"[40, p. 262]. If
true,the Millertheorywouldexplainthewidevariation
in leverageratesamongfirms.However,to me it seemed
impossiblefor the Millertheoryto be consistentwith
the MMtheoryif the latterwereextendedto allowthe
taxregimespecifiedbyMiller.I foundit mostpuzzling,
therefore,that the relation between Miller [40] and
MM [47] was not examinedeither by Milleror by the
subsequentliteraturethat referencedMiller'stheory.
My puzzlementcompelledme finallyto extendthe
MM theoremon capitalstructureto incorporatethe
tax regime explicitlystated in the Miller paper. As
describedin Gordon[25], I foundthe clientele effects
notedbyKim,Lewellen,andMcConnell[34]andothers.
However,with firmsdistributedin some wayover the
rangeof feasiblecapitalstructures,an equilibriumwas
reachedin whichthe valuesof firmsvariedwith their
leveragerates.Hence,as in the MMtaxmodel,allfirms
thatmaximizevaluearemotivatedto movetowardthe
maximumfeasible leveragerate.4Some years later, I
learned that one could reach Miller'scontrarycon-
clusion by assumingriskneutrality.He had implicitly
assumedthatthe bondsandthe sharesof a corporation
are equivalentand perfectsubstitutesfor each other,
exceptthat the intereston the bonds carriesthe label
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].
21
"deductibleas anexpensefor taxpurposes."I couldnot
at that time imaginethat the personwho hadenlarged
the theoryof corporatefinanceto recognizethe pres-
ence of uncertaintyand risk aversionwould subse-
quentlypresenta theorythat not only abandonedthis
assumptionbut do so withoutnotingit.5
The subsequentliteraturehas modified the MM
theoryin orderto reacha moreplausibleaccommoda-
tion with the stylizedfacts of capital structure.The
consensusreachedis thatthereis an interioroptimum
for the debt-equityratioand that this optimumbalan-
ces the tax-inducedgainfromleverageagainstthe costs
of bankruptcyand agency,both of which rise sharply
once the leverage rate passes some value.6 See, for
example,Bradley,Jarrell,andKim [7].
However,the evidencein supportof this consensus
is far from impressive.Whatwas the motive for debt
financingpriorto the impositionof the corporatein-
come tax?Whatis the evidencethat the presentvalue
of bankruptcyand agencycosts are large enough to
offsetthe taxandotherincentivesfor debtfinancingat
the verylow leveragerateswe actuallyobserve?Don't
the institutionalarrangementswhich limit personal
leverageto demand(margin)loans increasethe pref-
erencefor corporateleverage?To whatextentdo cor-
poratemanagementssubordinatethe maximizationof
marketvalue to the long-runsurvivalof the corpora-
tion in theircapitalstructuredecisions?Thirtyyearsof
preoccupationwith the defenseof MMhasproduceda
theoryof capitalstructurethat leavesthese and other
questionsunanswered.
In a presidentialaddressto the AmericanFinance
Association, Myers acknowledgedthat, "We do not
know how firms choose the debt, equity or hybrid
securitiesthat they issue"[48,p. 575]. Insteadof elab-
orating on the nature and source of his ignorance,
Myerswent on to offer two solutions to his capital
structurepuzzle.One is the vaguequalitativeconsen-
sus describedabove,andthe other is a restatementof
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
bankruptcyand 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
the traditional"peckingorder"theoryof capitalstruc-
ture.Firmsborrowbecausedebt is less attractivethan
retainedearningsbut moreattractivethannewequity.
Whatare the reasonsfor this peckingorderand how
does it result in the range of debt-equityratios we
observe?
Two furtherquestionson the consensusdescribed
earliermaybe noted.First,howdoes the valueof a firm
varywith its leveragerate and what rate maximizes
value? This is the centralquestion regardingcapital
structure,andalthougheconometricmethodshavebeen
improvedgreatly,nothinghasbeendone (to myknowl-
edge)overthe pasttwodecadesto advanceourempiri-
cal knowledgeof thisquestion.Why?Second,sincethe
taxbenefitfromleveragedependsnot on the corporate
taxratebut on its excessoverthe personaltaxrate,the
largegaincannotbe explainedby the taxsystemalone.
Whatelse is at work?
There is now a great interest in using signaling
theoryto explainfinancialbehavior.With respect to
capital structure,it is arguedthat the use of debt to
financean expansionis takenby the marketas a signal
thatthe stockis undervalued,in whichcasesignalingis
a source of covariationbetween leverageand value.
This may be true,7but we still have only a short-run
solutionto a short-runproblem.In the long run,firms
should be valued fairly and capital structureshould
serve other objectives.Otherwisea firm must per-
manentlymaintainthe higher leveragerate or, even
worse,continuouslyraisethe leveragerate in orderto
avoid issuing stock and therebysignalingovervalua-
tion.
II.DividendPolicy
MM [41] arguedthat the value of a corporationis
independentof its dividendpolicy.Theywouldbe cor-
rect if the sale of shareswere a perfectsubstitutefor
retainedearningsin financinginvestment,and if the
repurchaseof shareswerea perfectsubstitutefor divi-
dendsin makingdistributionsto shareholders.Both of
these conditionswouldbe trueunderthe perfectcapi-
tal marketsassumptionsstatedat the startof this pa-
per.However,we knowthatcapitalgainsenjoya more
favorabletax treatmentthan dividendsand that the
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.
FINANCIAL 1989
MANAGEMENT/SUMMER
transactioncosts for the issue of sharesis higherthan
for retainedearnings.WiththesedeparturesfromMM's
perfect capital marketsassumptions,the value of a
company'sstock is maximized(i) when investmentis
financedthroughretainedearningsratherthanthrough
the sale of shares,and(ii)when distributionsto share-
holders are made throughthe repurchaseof shares
rather than through the paymentof dividends.For
those who acceptthe MMtheoremon dividendpolicy
as being true in the absenceof taxes and transaction
costs, the widespreadpracticeof payingdividendsre-
sults in the "dividendpuzzle"describedby Black [5]
(whichwill be discussedlater).
MM [42] tested their dividendpolicy theorem as
well as theirleveragetheorem.Forthe formertest,they
seemed to acknowledgethat there is covariationbe-
tweenthe dividendandvalue;reconciliationwiththeir
theorywas accomplishedby abandoningtheir perfect
capitalmarketsassumptionthat all participantsin the
markethave equal information.They arguedthat the
covariationis due not to the dividendper se but to the
informationaboutearningsthat managementconveys
throughits dividend.Accordingly,theycarriedout two
regressionsof valueon variablestheycalled"earnings"
and "dividendpolicy."One was a simple regression,
andthe otherwas a two-stageregression in whichthe
earningsfigurewas changedto incorporateinforma-
tion on earningscontainedin the dividend,and the
dividendpolicyfigurewaspurgedof the information.
The test results presentedin MM [42, Table 5, p.
369]revealthatthe earningscoefficientwasoverthirty
timesits standarderrorin each of the threeyearsused
in theirtests, andthese resultswere practicallyidenti-
cal both with and without the dividendinformation.
Withoutremovalof its informationcontent, the divi-
dend policycoefficientwas positivein all threeyears,
but it was significantlydifferentfromzero in only one
year. With removal,it becamenegative,but also not
significantlydifferentfromzero. Notwithstandingthe
fact thatthe earningscoefficientswereunchangedand
the dividendcoefficientswere effectivelyzero in both
regressions,MMtook the changein signas evidencein
supportof theirtheory.8
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.
 FINANCEUNDERTHEMMTHEOREMS
GORDON/CORPORATE
The MM theoremthat the value of a firm is inde-
pendentof its dividendpolicyimpliesthatthe expected
return on a share is independentof its distribution
betweendividendyield andgrowth.BrighamandGor-
don [9] tested this implicationthroughcross-section
regressionsof dividendyield on growthleverageand
other variables.The growthcoefficientwas so much
largerthan minus one (the value predictedby MM)
that strongreasonwas providedfor believingthat the
riskof growthmakesthe expectedreturndeclineas the
fractionof earningspaidin dividendsrises.9
That is where the matter stood empiricallyuntil
Blackand Scholes [6] presenteda new test of the MM
theorem.Theyclaimedthatthe dataareconsistentwith
MM, if a regressionof expectedreturnon beta and
dividendyield result in a coefficientof about zero on
the dividendyield.Theyfoundthat resultby meansof
a new,massive,andcomplexeconometricformulation
of the problem,one that took advantageof the meth-
odologydevelopedat Chicagofor testing the CAPM.
This methodologytakes as the expectedreturnan av-
erageof the realizedholdingperiodreturnovera prior
time period.The absenceof correlationwith the divi-
dend yield that they found is consistent with three
alternativepropositions:(i) the MM assumptionsare
true; (ii) the covariationin expectedreturnand divi-
dendyielddue to the taxsystemis offsetby the inverse
variationdue to the risk of growth;and (iii) the noise
in their measurementof the variablesand their for-
mulationof the problemsimplyresultedin no correla-
tion.
LitzenbergerandRamaswamy[37]foundsignificant
positivecorrelationbetweenexpectedreturnand divi-
dendyield.Undertheirmethodology,the dividendyield
is thedividendpaiddividedbythepriceintheex-dividend
months,butit is zeroin the monthsthata sharedoesnot
go ex-dividend. Hence,theirresultsconfirmedthe Elton-
Gruber[12]findingthata share'spricefallsby less than
the fullamountof the dividendwhenit goesex-dividend.
However,this resulttells us absolutelynothingabout
whathappensto a share'sexpectedreturnwhendividend
policychanges,that is, when there is a changein the
fractionof long-runearningspaidin dividends.
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
inverselywith 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.
23
MillerandScholes[44]andLitzenberger andRama-
swamy[38] engagedin a spiritedcontroversyon the
interpretationof the covariationin averageholding-
period returnand dividendyield that was foundin all
of the cited empiricalwork except Black-Scholes[6].
Whatthisdebateandthe empiricalworkcitedfailedto
recognizeis that a positivecoefficienton the dividend
yield is consistentwith an inversecorrelationbetween
expectedreturnanddividendyield.Fewings[18]showed
that under plausibleassumptionsgrowth is risky,in
whichcase beta and dividendyieldwouldbe inversely
correlated.He foundpositivecorrelationbetweenbeta
and growth,and Hochman[31], amongothers,found
negativecorrelationbetweenbeta and dividendyield.
Hence,dependingon the relativeimportanceof the tax
andriskeffects,the positivecoefficienton the dividend
yield may be more than offset by the productof the
positivecoefficienton betaandthe changein betawith
the dividendyield.See also Gordon[27,pp. 86-88].
There has been a considerablebody of empirical
researchto determineif the change in price with a
dividendchangedoes or does not takeplaceapartfrom
anychangedue to earningsannouncements.The pre-
sumptionbehind this literatureis that the favorable
conclusion supportedby the data confirmsthe MM
hypothesisthatcovariationbetweendividendandprice
is not due to the dividendperse but to the information
in the dividendaboutearnings.Butwhatis the distinc-
tion betweena variableandthe informationit conveys,
when the past is of interestonly for the informationit
conveysabout the future?Furthermore,I fail to see
why a changein the dividenddoes not simplyconvey
informationabout a change in future dividends.Of
course, an unexpectedrise in the dividendconveys
informationthat futureearningsas well as dividends
willbe higherthanpreviouslyexpected,unlessa change
in the payoutrate is also expected.Dividendpolicyis
payoutpolicy,so thatthisline of reasoningandempiri-
cal work in which the payout rate is not among the
variablesthat explainsharevalue has no relevancefor
the MMtheoremon dividendpolicy.10
Returningto the questionof whycorporationspay
dividends,the answerlies in a simpler,morereasonable
interpretationthanMM'sof the informationconveyed
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
bythe dividend.Withoutquestion,the valueof a share
is the presentvalue of its expectedfuture payments.
These paymentsare the dividendsand share repur-
chasesexpectedfor eachof n periodsplusthe expected
priceat the end of the n periods.The latterdependson
the paymentexpectationbeyondthe n periods,andthe
conditionsunderwhich share repurchasestake place
cause them to convey little or no informationabout
future repurchases.It follows that corporationspay
dividendsfor the plain and simple reason that the
dividendrecordis a veryimportantsourceof informa-
tion on futuredividends,andthe currentpricedepends
on the expectationof future dividends,not just on
paymentsin general.
The massiveevidencethat shareprice is not inde-
pendentof dividendpolicypersuadedme to go beyond
testingwhetheror not the MM theoremis trueand to
ask instead how investorsvalue shares. Since price
dependsin facton expectedfuturedividends,the prob-
lem is to arriveat a representationof the expectation
that is plausibleandmakesuse of history.Gordonand
Gould [28] presenteda solutionto the problemthat is
of interestfor the followingreasons.First,our model
implicitlyassumedthat a firm'sinvestmentopportu-
nities, unlike those availableto a portfolio investor,
dependupon the firm'spast history.To withdrawthat
assumptionwouldimplythatall personsandfirmshave
the same investmentopportunities,in whichcase the
valueof a firmwouldbe independentof its investment
decisionaswell as independentof its financing.In such
an ideal world,investmentas well as financingpolicy
would not matteron the level of the firm.Second,in
our modelgrowthis riskyfromthe shareholder'sview-
point, so that the cost of capitalis an increasingfunc-
tionofthegrowthrateincapital.Finally, alltheconclusions
reachedpreviouslywith retainedearningsas the sole
sourceof equityfundswereshownto hold if the firmis
also representedas being expectedto issue or repur-
chasesharesat somerateperannum.Hence,ourmodel
also explainshowsharepricevarieswitha firm'sequity
financingon that distantplanet where dividendsand
sharerepurchasesare perfectsubstitutes.
The treatmentof our model in the literatureis 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
FINANCIAL 1989
MANAGEMENT/SUMMER
thatas earlyas Gordon[20]the modelwasgeneralized
to includeboth sourcesof equityfunds.
Perhapsto give an empiricalbasisfor the Brennan
thesis,Fama[14, p. 317] claimedto havefoundthat:
"Whateverimperfectionsare present in the capital
market are not sufficient to cause our data to reject
the hypothesisthat there is a rathercomplete degree
of independence between the dividend and invest-
ment decisions offirms. "
WhatFamaactuallyfoundwas no correlationin year-
to-yearmovementbetween the dividendsand invest-
ment of firms.However,for his datato be evidenceof
the MM theoryon dividendpolicy,there mustalso be
independencebetweeninvestmentand retainedearn-
ings-since MM claimsthat firmsare indifferentas to
the sourceof fundsusedto financeinvestment.To test
thishypothesis,Gordon[23]examinedtheyear-to-year
movementin investmentand retainedearningsfor a
largesampleof firms.The data,of course,revealedvery
high correlationbetween these variables.It also re-
vealed that the sale of shareswas a materialsourceof
funds only for exceptionallyprofitablefirms,and for
them it was a complimentto and not a substitutefor
retainedearnings.The explanationfor Fama'sfinding
is the well-knownfact,firstnotedby Lintner[36],that
the informationin the dividendpersuadescorpora-
tions to maketheirdividendsindependentof the year-
to-yearfluctuationsin earningsandinvestment.Further
evidence that investmentis correlatedwith internal
funds is presentedin a recentstudyby Fazzari,Hub-
bard,andPetersen[17].
Before proceeding,it maybe noted that the litera-
ture on dividendpolicyhas consideredother topics in
informationeconomics and other market imperfec-
tions. For a reviewof this literature,see Ang [1] and
the referencescited there.
III.CorporateObjectives
TheMMtheoryof corporatefinanceclaimsnot only
that the currentmarketvalue of a firmis independent
of the methodof financing,but also thatthe firm'ssole
objectiveis to maximizethatvalue.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
 FINANCEUNDERTHEMMTHEOREMS
GORDON/CORPORATE
financeliteraturewasat mostmarginalpriorto papers
by Ross [49] andbyJensenandMeckling[33].
The latterpaperextendedthe MMtheoryto recog-
nize the consequencesof agency under asymmetric
information whenthecorporationhasbothinsideshare-
holders(who havesome measureof control)and out-
sideshareholders(whoarepassiveportfolioinvestors).
It assumedthat both types of shareholderswant the
corporationto make the decisionsthat maximizethe
currentmarketvalue of their respectivenet worths.
However,the net worth of the insiders includes, in
additionto the valueof theirshares,the presentvalue
of the benefitstheycanextractfromthe corporationby
virtueof theircontrolposition.Perquisitesis the term
usedto referto thosebenefitsthatarebeyondwhatthe
insidersrightfullyearnandareobtainedat a cost to the
shareholdersas awhole.JensenandMeckling[33]have
enlargedour understandingof how agencyand asym-
metricinformationmayinfluencethe termsandvalua-
tion of corporatesecurities.However,with respectto
the fundamentalquestionsof corporatebehaviorand
valuation,all they did was extend the MM theory to
incorporatethe takingof perquisitesby insiders.
The importanceof perquisitesshouldnot be over-
stated. The large, publiclytraded,and management
controlledcorporationhascometo occupya dominant
place in the Americaneconomy,a developmentwhich
would havebeen impossibleif the takingof such per-
quisiteshadnot been broughtwithinreasonablelimits
or been madeto take formsthat are sociallyconstruc-
tive. A farbetterunderstandingof the investmentand
financingbehaviorof managementcontrolledcorpora-
tions can be obtainedby going beyondthe workdone
by Jensen and Mecklingon the subject."1Recall that
portfolio investorswant the corporationto maximize
currentmarketvaluewithoutregardforwhatthismight
do to the probabilityof bankruptcyone or more peri-
ods hence.Thereasonis thattransactionson personal
accountallow a portfolio investorto make her prob-
abilityof bankruptcyindependentof the probabilityfor
each andeverycorporationin her portfolio.The same
is not true of a corporation'smanagementor of its
insideshareholders.Theirhumanand/orsharecapital
11"Jensenand 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].
25
canbe andarediversifiedto onlya verylimiteddegree.
Hence, the presentvalue of their future income,and
even more so the utility of that future income, are
reducedas the probabilityof bankruptcyfor the cor-
porationincreases.In addition,the presentvalue and
utilityof theirfutureincomeincreasewith the corpo-
ration'sexpectedgrowthrate for two reasons.First,
management'sopportunitiesfor promotion increase
with the corporation'sgrowth.Second, as shown in
Gordon [24],growthreducesthe probabilityof bank-
ruptcyso thatgrowthandriskare inverselycorrelated,
the oppositeof whatis true in the pricingof shares.
The above considerationssuggest that a manage-
ment's self-interestis served by an investmentand
financingpolicythatmaximizesthe probabilityof long-
run growthand survivalfor the corporation.That ob-
jectivewouldleadmanagementto payno dividendsand
adopt a veryconservativedebt-equityratio. However,
the threat of a hostile takeover of the corporation
increaseswith the shortfallin the actual price of the
stock from the maximumfeasible price. Hence, the
financialpolicies actuallyfollowedare a compromise
betweenvaluemaximizationandavoidanceof a hostile
takeover.Where the compromiseis reacheddepends
uponhowfavorablethe legalandinstitutionalenviron-
ment is for such takeovers.Chamberlainand Gordon
[10] formulatedan investmentmodel that captures
management'sconcernfor long-rungrowthand sur-
vivalandfoundthe evidenceconsistentwith that con-
cern.
To the degree that a managementdoes not feel
threatenedby a hostile takeover,its investmentand
financingpolicies departfrom the objectiveof value
maximization.In particular,the firmwill pay a lower
dividendand have a higherrate of growthin tangible
andintangible(research,development,advertising, etc.)
capitalthan it would undervalue maximization.This
departurefrom value maximizationwould be ineffi-
cientif allmarketswereperfectlycompetitive.Theyare
not. In particular,there is very strong evidence that
managementcompensationis not sensitiveto perfor-
mance, either of the individualor of the firm. See
Medoff and Abraham[39], Lawler [35], and Baker,
Jensen,andMurphy[3].It wouldseem,therefore,that
the promotionsandjob securitythataccompany growth
figure prominentlyin the way managementsharesin
the returnsfrom its outstandingperformance.Elimi-
natingthese rewardsmaybe morecostlythanallowing
profitablecorporationsto overinvest.In other words,
usinga lowerdiscountrate in its investmentdecisions
26
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 barriersto 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
proprietorshipand 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
transferswere quite unsatisfactorywhen 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
FINANCIAL 1989
MANAGEMENT/SUMMER
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 hundredyears ago they were either
proprietorships or partnerships, with a few crown cor-
porations created to exploit monopoly privileges. To-
day, the business sector in advancedcapitalist 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-
 FINANCEUNDERTHEMMTHEOREMS
GORDON/CORPORATE
tion of perfect capital markets.However,few of our
politicalleadersandcorporateexecutiveslook on cor-
porationsas legal fictions, and their ranksare being
joined by an increasingnumber of economists. An
articleon the RJR Nabiscoleveragedbuyoutby John
Greenwald[30] in TimequotedJohn Creedon,presi-
dentof Metropolitan Life,as saying,"Whatisbeingdone
threatensthe very basis of our capitalistsystem."Of
even more interest here, the article then quoted a
leadingeconomistas saying:
"Highleverageis unsafe,notjustfor a companybut
the entireeconomy.....LBOs are reducingthe safety.
Managementloses thepowerto do manythings.It
has no marginfor errorandlessmarginfor addition-
al risk."
The authorof this statementis FrancoModigliani!
References
1. J.S. Ang, Do Dividends Matter?A Review of CorporateDividend
TheoriesandEvidence,NewYork,NewYorkUniversity,1987.
2. F. Arditti,H. Levy,andM.Sarnat,"Taxes,CapitalStructureand
the Costof Capital:SomeExtensions,"
QuarterlyReviewof Eco-
nomics and Business (Summer 1977), pp. 89-95.
3. G.P.Baker,M.C.Jensen,andK.J.Murphy,"Compensation and
Incentives:Practicevs. Theory,"Journalof Finance(July1988),
pp. 593-617.
4. A.A. Berle, Jr. and G.C. Means, The Modem Corporation and
PrivateProperty,New York, Macmillan, 1932.
5. F. Black, "The Dividend Puzzle," Journal of Portfolio Manage-
ment(Winter1976),pp.5-8.
6. F. BlackandM.S.Scholes,"TheEffectsof DividendYieldand
DividendPolicyon CommonStockPricesandReturns,"Journal
of Financial Economics (May 1974), pp. 1-22.
7. M.Bradley,G.A.Jarrell,andE.H.Kim,"OntheExistenceof An
OptimalCapitalStructure:Theoryand Evidence,"Journalof
Finance(July1984),pp. 857-878.
8. M.J.Brennan,"ANote on DividendIrrelevance andtheGordon
ValuationModel,"Journalof Finance(December 1971), pp.
1115-1122.
9. E.F.BrighamandM.J.Gordon,"Leverage, DividendPolicy,and
the Costof Capital,"TheJournalof Finance(March1968),pp.
85-103.
10. T. Chamberlainand M.J.Gordon,"Liquidity,Profitabilityand
Long-RunSurvival:Theoryand Evidenceon BusinessInvest-
ment," Journal of Post KeynesianEconomics (forthcoming).
11. D. Durand,"TheCostof Capital,CorporationFinance,andthe
Theory of Investment: Comment,"American Economic Review
(September1959),pp. 639-655.
12. E. EltonandM. Gruber,"Marginal
StockholderTaxRatesand
the Clientele Effect," ReviewofEconomcsand Statistics(February
1970),pp. 68-74.
13. - , "Valuationand the Cost of Capitalfor Regulated
27
Utilities:Reply,"Journalof Finance(December1972),pp. 1150-
1155.
14. E.F.Fama,"TheEmpiricalRelationshipsBetweentheDividend
and Investment Decision of Firms,"AmericanEconomic Review
(June1974),pp. 304-318.
15. - , "The Effects of a Firm'sInvestmentand Financing
Decisions on the Welfareof Its SecurityHolders,"American
EconomicReview(June1978),pp. 272-284.
16. D.E.FarrarandL.L.Selwyn,"Taxes,CorporateFinancialPolicy,
and Returnsto Investors,"National TaxJournal(December
1967),pp. 444-454.
17. S.M. Fazzari,R.G. Hubbard,and B.C. Petersen,"Financing
Constraintsand CorporateInvestment,"BrookingsPaperson
Economic Activity (April 1988), pp. 141-195.
18. D.R. Fewings,CorporateGrowthand Common StockRisk,Green-
wich,CT,JAIPress,1979.
19. M.C.FindlayandE.E. Williams,"APositivistEvaluationof the
New Finance,"FinancialManagement (Summer 1980), pp. 7-17.
20. M.J. Gordon, The Investment,Financing and Valuation of the
Corporation, Homewood,IL, R.D. Irwin,1962.
21. - , "SomeEstimatesof the Costof Capitalto the Electric
Utility Industry,1954-1957:Comment,"AmericanEconomic
Review(December1967),pp. 1267-1278.
22. - , The Cost of Capitalto a Public Utility,East Lansing, MI,
MichiganStateUniversity,1974.
23. - , "TheEmpiricalRelationshipsBetweenthe Dividend
and InvestmentDecisionsof Firms:Comment,"Unpublished
Manuscript,Universityof Toronto,1977.
24. - , "GrowthandSurvivalin a CapitalistSystem,"Journal
of Post KeynesianEconomics (Summer 1980), pp. 443-458.
25. - , "LeverageandtheValueof a FirmUndera Progressive
Income Tax,"Journalof Bankingand Finance (December 1982),
pp. 433-443.
26. - , "LeverageandtheValueof a FirmUndera Progressive
Income Tax:Reply,"JournalofBanking and Finance (September
1984),pp. 495-497.
27. - , "WhyCorporations PayDividends,"inStudiesinBank-
ing and Finance,M. Sarnatand G.P.Szego(eds.),Amsterdam,
NorthHolland,1988,pp. 77-96.
28. M.J.Gordonand L.I. Gould, "TheCost of EquityCapital:A
Reconsideration,"Journalof Finance(June1978),pp.849-861.
29. M.J.GordonandE. Shapiro,"CapitalEquipmentAnalysis:The
RequiredRateof Profit,"Management Science(October1956),
pp. 102-110.
30. J. Greenwald,"Where'sthe Limit?,"TimeInternational (De-
cember5, 1988),pp. 40-44.
31. S.J. Hochman,"TheBeta Coefficient-An InstrumentalVari-
ableApporach," Ph.D.Dissertation,
Universityof Toronto,1980.
32. J.F. Jaffeand R.W.Westerfield,"Leverageandthe Valueof a
FirmUndera ProgressiveIncomeTax:A CorrectionandExten-
sion," Journal of Banking and Finance (September 1984), pp.
491-494.
33. M.C.Jensenand W.H.Meckling,"Theoryof the Firm:Mana-
gerialBehavior,AgencyCosts,andOwnershipStructure,"
Jour-
nal of Financial Economics (October 1976), pp. 305-360.
28 FINANCIAL 1989
MANAGEMENT/SUMMER

34. E.H. Kim,W.G.Lewellen,andJ.J.McConnell,"FinancialLev-
erage Clienteles,Theoryand Evidence,"Journalof Financial
Economics(March1979),pp. 83--109.
35. E.E. Lawler, III, Pay and OrganizationEffectiveness:A Psycho-
logicalView,NewYork,McGrawHill, 1971.
36. J. Lintner,"Distributionof Incomesof Corporationsamong
Dividends, Retained Earnings, and Taxes,"AmericanEconomic
Review(May1956),pp.97-113.
37. R.H.Litzenberger
andK.Ramaswamy, "TheEffectsof Personal
Taxesand Dividendson CapitalAsset Prices:TheoryandEm-
pirical Evidence," Journal of Financial Economics (June 1979),
pp. 163-195.
38. - , "TheEffectsof Dividendson CommonStockPrices:
TaxEffectsor InformationEffects?,"Journalof Finance(May
1982), pp. 429-443.
39. J.L.MedoffandK.G.Abraham,"Experience,
Performanceand
Earnigs,"QuarterlyJournal of Economics (December 1980), pp.
703-736.
40. M.H. Miller, "Debt and Taxes,"Journal of Finance (May 1977),
pp. 261-275.
41. M.H.Millerand F. Modigliani,"DividendPolicy,Growth,and
the Valuationof Shares,"Journalof Business(October1961),
pp.411-433.
42. , "SomeEstimatesof the Costof Capitalto the Electric
Utility Industry, 1954-1957," American Economic Review (June
1966),pp. 333-391.
43. - , "SomeEstimatesof the Costof Capitalto the Electric
Utility Industry,1954--1957:Reply,"AmericanEconomic Review
(December1967),pp. 1288-1300.
44. M.H. Millerand M.S. Scholes, "Dividendsand Taxes:Some
Empirical Evidence," Journal of Political Economy (December
1982),pp. 1118-1141.
45. F. ModiglianiandM.H.Miller,"TheCostof Capital,Corpora-
tionFinance,andtheTheoryof Investment,"
AmericanEconomic
Review(June1958),pp. 261-297.
46. - , "The Cost of Capital,CorporationFinance,and the
Theory of Investment:Reply,"AmericanEconomic Review(Sep-
tember1959),pp. 655-669.
47. - , "CorporateIncomeTaxesandThe Costof Capital:A
Coorection," American Economic Review (June 1963), pp. 433-
443.
48. S.C.Myers,"TheCapitalStructurePuzzle,"Journalof Finance
(July1984),pp. 575-592.
49. S.A. Ross, "TheEconomicTheoryof Agency:The Principals
Problems," American Economic Review (May 1973), pp. 134-
139.
50. S.A. Ross and R.W.Westerfield,Corporate
Finance,St. Louis,
TimesMirror,1988.
51. M.E. Rubinstein,"A Mean-VarianceSynthesisof Corporate
FinancialTheory,"Journalof Finance(March1973),pp. 167-
181.
52. J.E.Stiglitz,"ARe-Examination
of the Modigiani-Miller
Theo-
rem," American Economic Review (December 1969), pp. 784-
793.
53. R.F. Wippern,"FinancialStrcutreandthe Valueof the Firm,"
TheJournal of Finance (December 1966), pp. 615-633.

CALL FOR PARTICIPATIONAND PROPOSALS

The Midsouth Academy of Economics and Finance invites you to participatein the 17th annual meeting in Jackson, MS,
February 7-10, 1990. Our 1989 meeting in Nashville, TN attracted nearly 300 participantsfrom 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 Participationform (availablefrom 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 registrantscan be published in the proceedings of the annual meeting, provided that the
final copy meets the standardsand deadlines establishedby 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.