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FRANCO MODIGLIANI

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Born June 18, 1918 Rome, Italy

Died

September 25, 2003(aged 85) Cambridge, Massachusetts

Nationality Field

Italian, American Financial economics

Contributions

ModiglianiMiller theorem Life-cycle hypothesis

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Life and career

Modigliani Born in Rome, he left Italy in 1939 because of his Jewish origin. He first went to Paris with the family whom he married in 1939, and then go to the United States. From 1942 to 1944, he taught at Columbia University and Bard College as an instructor in economics and statistics. In 1944, he obtained his D. Soc. Sci. from the New School for Social Research working under Jacob Marschak. In 1946, he became a naturalized citizen of the United States, and in 1948, he joined the University of Illinois at Urbana-

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When he was a professor at the Graduate School of Industrial Administration of Carnegie Mellon University in the 1950s and early 1960s, Modigliani made two path-breaking contributions to economic science: Along with Merton Miller, he formulated the important ModiglianiMiller theorem in corporate finance. This theorem demonstrated that under certain assumptions, the value of a firm is not affected by whether it is financed by equity (selling shares) or debt (borrowing money). He was also the originator of the life-cycle hypothesis, which attempts to explain the level of saving in the economy. Modigliani proposed that consumers would aim for a stable level of consumption throughout their lifetime, for example by saving during their working years

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In 1962, he joined the faculty at MIT, achieving distinction as an Institute Professor, where he stayed until his death. In 1985 he received MIT's James R. Killian Faculty Achievement Award. Modigliani also co-authored the textbooks, "Foundations of Financial Markets and Institutions" and "Capital Markets: Institutions and Instruments" with Frank J. Fabozzi of Yale School of Management. In the 1990s he teamed up with Francis Vitagliano to work on a new credit card, and he also helped to oppose changes to a patent law that would be harmful to inventors. For many years, he lived in Belmont, Massachusetts; he died in Cambridge, Massachusetts.

Noble prize and contribution

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Franco Modigliani, an American born in Italy, received the 1985 Nobel Prize on the basis of two contributions. The first is his analysis of the behavior of household savers.In the early 1950s Modigliani, trying to improve on Keyness consumption function, which related consumption spending to income, introduced his life cycle model of consumption. The second contribution that helped Modigliani win the Nobel Prize is the famous Modigliani-Miller theorem in corporate finance (see corporate financial structure). Modigliani, together withMerton Miller, showed that under certain assumptions, the value of a firm is independent of its ratio of debt to equity.

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THEORIES BY MODIGLIANI

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THEORIES

ModiglianiMiller theorem The ModiglianiMiller theorem (of 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. Modigliani was awarded the 1985 Nobel Prize in

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Consider two firms which are identical except for their financial structures. The first (Firm U) isunlevered: that is, it is financed byequityonly. 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.

Propos Vu ition I: Where Vu=V the value of an is L unlevered firm= price of buying a

Without taxes

firm composed only of equity, andVL is the value of a levered firm= price of buying a firm that is composed of some mix of debt and equity. To see why this should be true,

This discussion also clarifies the role of some of the theorem's assumptions. We have implicitly assumed that theinvestor'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:.

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

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

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assumptio ns:

No transaction costs exist. individuals and corporations borrow at the same rates. in the absence of taxes. No bankruptcy costs. No agency costs.

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With taxes:
Propos ition I: Wher e VL- is the value of a levered firm. Vu- is the value of an is the tax rate unlevered firm. (Tc)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

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Propositio n II: re 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 orcost of debt is the debt-to-equity ratio. is the tax . rate.

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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 theWACC. 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%.

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The following assumptions are made in the propositions with taxes.

corporations are taxed at on earnings after the rate interest. no transaction costs exist. The theorem was first proposed by F. Modiglian M. Miller in 1958.

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Life-cycle hypothesis:

In economics, the life-cycle hypothesis (LCH) is a concept addressing individual consumption patterns. The life-cycle hypothesis implies that individuals both 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. The key assumption is that all individuals choose to maintain stable lifestyles. This implies that they usually don't save up a lot in one period to spend furiously in the next period, but keep their consumption levels approximately the same in every period.

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The Hypothesis:

Assume that there is a consumer who expects that he will live for anotherTyears and has wealth ofW. The consumer also expects to annually earn incomeYuntil he retiresRyears from now. In this situation, the consumer's resources over his lifetime consist both of his initial wealth endowment,W, and of his lifetime earnings,RY. Note that the interest rate is assumed to be zero.

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The consumer can distribute his lifetime resources over the remainingTyears of his life. He divides W+RYequally amongTyears 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.

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whereais the marginal propensity to consumefor wealth andbis the marginal propensity to consume for income.

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Implications:

From the equation given above, it is clear that if the income falls to zero the amount of consumption will be equal toaW. 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

However, generally over a long period of time, wealth and income increase together which leads to a constant ratioWYand thus a constant average propensity to consume. ASSUMPTIONS Saving and Wealth when Income and Population are stable.

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In an unpublished paper written with R. Brumberg, it was observed that 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 until retirement and so is the rate of consumption combined with a zero rate of return on net wealth will remain constant in totality even though worth . it is constantly being transferred from dissavers to savers in exchange for current resources.

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The Effect of Population Growth

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 pthen both population and the aggregate income will grow at the ratep. 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.

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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 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.

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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. Theory and Evidence

The findings of many economists bring out a problem in the life-cycle model. It was found out that the elderly do not dissave as quickly as has been said in the model. 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.

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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. 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. Overall research on the retired section of the society show that the life-cycle model cannot completely explain consumer behaviour.

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Franco Modigliani Books:

1-Adventures of an Economist. 2-Rethinking pension reforms.

Working papers:

Towards An Understanding of the Real Effects and Costs of Inflation.

The Monetary Mechanism and Its Interaction Phenomena.

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THANK YOU