Merton Miller and Modern Finance

Financial Management (Financial Management Association), Winter, 2000 by Rene M. Stulz

Rene M. Stulz [*]

In this keynote address to the 2000 Financial Management Association International Annual Meeting, I consider Merton Miller's contributions to the field of finance. I argue that his most important contribution is to have made arbitrage arguments the cornerstone of modern finance. The arbitrage proof of Proposition I introduced a new standard in finance, namely that any result the finance profession takes seriously must have the critical property that it cannot be undermined by clever arbitrageurs. I show how arbitrage is a constant theme in Merton Miller's career from his work in corporate finance to his analyses of financial innovation, financial crashes, and crises.

Most of us learned first about how much finance owes to Merton Miller in our Ph.D. studies. I was lucky to be a Ph.D. student at MIT in the late 1970s. Throughout my studies, Merton Miller seemed omnipresent in the courses I took and in his influence on everybody connected with finance. He defined the field and shaped it by his actions. When we talked about the BlackScholes formula, Merton Miller had played an important role in getting the paper published after it had been turned down by two journals. He had taken Fischer Black, who was then at MIT, from his work as a consultant to make him a full professor at the University of Chicago. In Robert Merton's asset pricing course, we learned that Merton Miller had defined the rules for empirical tests of the capital asset pricing model in his critique of the Douglas study with Myron Scholes. In Stewart Myers' corporate finance course, we obviously talked about the Modigliani-Miller papers, but at that time corporate finance's attention was turned to Merton Mille r's address as president of the American Finance Association. Even in monetary economics courses, he was there in full force with one of his most beautiful papers, the Miller and Upton model of the demand for money.

For the 20 years after I received my Ph.D., finance was a field young enough that most of its founding fathers were active and still influencing its development. At the center of these founding fathers stood Merton Miller. For many people in finance, he played a key role in their career. Obviously, this was the case for the large number of Ph.D. students whose dissertation he supervised. Many of these students became stars in our profession - one received a Nobel prize. However, besides his students, he had a direct impact on many careers. Even though I never took a course from him, he was one of my most important finance teachers. I spent one year at the University of Chicago. I discovered early in that year that I could learn a lot of finance by joining Merton Miller's lunch group at the faculty club. In addition to learning finance, I learned about all sorts of other things, because he was always fascinating. He was an important reason why I became editor of the Journal of Finance, and he never stopped he lping me during my years as editor. Even when his influence was not direct and personal, it was never possible to do much in finance without being reminded of his contributions and of his presence. He was always there, trying to push forward the field that he had played such a key role in creating. Nobody else deployed such energy and skills in advancing our profession. Even in his last stay at the hospital, he was still concerned about mistakes he thought were being made that he had to correct. At that point, he had finished the first draft of a paper and was waiting to go back home to finish it and submit it to a journal.

We can list many reasons why Merton Miller was so important to our field, but his contribution to our field transcends the list of his accomplishments. He was unique, and so we have to focus on why he was so unique. If we had to remember one thing about Merton Miller's contribution to finance, what would it be? Many financial economists are likely to answer that question by saying that we should remember the irrelevance propositions. I am going to start with a discussion of these propositions, but my purpose in doing so is to convince you that, even though any finance academic would be thrilled to have produced any one of these results, we should not think that Merton Miller's most important contribution to our field consists of the propositions themselves. To make my case, I will only talk about the first Modigliani and Miller paper. The most important result of the paper is the famed Proposition I which states that "the market value of any firm is independent of its capital structure and is given by capita lizing its expected return at the rate (...) appropriate to its class."

It is ironic that this leverage irrelevance result is what many may want to remember from Merton Miller. After all, Modigliani and Miller themselves write in the paper that "A number of writers have stated close equivalents of our Proposition I..." They then cite works by Williams, Durand, and Morton in a footnote. Further, financial economists generally do not view Proposition I as a statement of the role of leverage in the real world--especially not for high levels of leverage. Proposition I is derived using the assumption that cash flows are unaffected by capital structure. Much of the literature in corporate finance since then has focused empirically and theoretically on whether investors' expectations about cash flows and cash flows themselves are affected by capital structure. Work in the 1970s, including Merton Miller's best book, the Theory of Finance with Eugene Fama, made clear the conditions that must be met for cash flows not to be affected by a firm's capital structure. At the very least, howeve r, the consensus among financial economists is that often capital structure does affect the present value of cash flows.