• Raghuram Rajan

The Corporation in Finance

One of the cornerstones of modern corporate finance is the Modigliani Miller Theorem, which essentially says that in a world where investors can borrow and lend as easily as corporations, the value of a firm is determined by the present discounted value of its expected cash flows, and not by how these cash flows are allocated to various claimholders—i.e., by its capital structure. One of the important assumptions of the Modigliani Miller Theorem is the very existence of the corporation. In the largely perfect world envisioned by Miller and Modigliani, it is not clear what, if anything, determines the existence of the corporation and how it is structured. As researchers on the theory of the firm such as Ronald Coase, Oliver Hart, and Oliver Williamson have suggested, firms with well-defined boundaries emerge in worlds with transactions costs stemming from difficulties in contracting. But these costs are unimportant in the Modigliani Miller world. So the Modigliani Miller postulates the irrelevance of corporate capital structure in a world where corporations are also irrelevant in the first place. Put differently, could the imperfections that lead to the firm being organized in a particular way also lead to implications for its capital structure, and vice versa. That is indeed what I argue in this paper.

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