1988 Articles

Why Financial Structure Matters

Stiglitz, Joseph E.

This article comments on the paper The Cost of Capital, Corporation Finance and the Theory of Investment, by Franco Modigliani and Merton Miller that was published in the June 1958 issue of the periodical American Economic Review. The fact that the optimal financial structure depends on tax rates, and that different investors face markedly different tax rates means, of course, that different firms should have different clientele. If those versions of the capital valuation model which assert the existence of a large number of similar firms were correct, then there would be some firms which pursued an all debt policy, others an all equity policy, and still others a historical policy of the kind described above; within any risk class firms in each category would have distinctly different owners. Though firms may differ somewhat in their clientele, they do not differ in the marked way predicted by the theory. Modigliani and Miller, in their brilliant papers, have set forth a research agenda which will occupy economists for decades to come. The direction which Modigliani and his co-authors suggest in their recent work, a systematic exploration of market irrationalities, seems among the most fruitful for enhancing our understanding of these hitherto unexplained quandaries.