MODIGLIANI AND MILLER:THEORY OF INVESTMENT 263 as large and as direct an influence on the rate of investment as this analysis would lead us to believe.At the microeconomic level the cer- tainty model has little descriptive value and provides no real guidance to the finance specialist or managerial economist whose main problems cannot be treated in a framework which deals so cavalierly with uncer- tainty and ignores all forms of financing other than debt issues. Only recently have economists begun to face up seriously to the prob- lem of the cost of capital cum risk.In the process they have found their interests and endeavors merging with those of the finance specialist and the managerial economist who have lived with the problem longer and more intimately.In this joint search to establish the principles which govern rational investment and financial policy in a world of uncer- tainty two main lines of attack can be discerned.These lines represent, in effect,attempts to extrapolate to the world of uncertainty each of the two criteria-profit maximization and market value maximization- which were seen to have equivalent implications in the special case of certainty.With the recognition of uncertainty this equivalence vanishes. In fact,the profit maximization criterion is no longer even well defined. Under uncertainty there corresponds to each decision of the firm not a unique profit outcome,but a plurality of mutually exclusive outcomes which can at best be described by a subjective probability distribution. The profit outcome,in short,has become a random variable and as such its maximization no longer has an operational meaning.Nor can this difficulty generally be disposed of by using the mathematical expecta- tion of profits as the variable to be maximized.For decisions which affect the expected value will also tend to affect the dispersion and other characteristics of the distribution of outcomes.In particular,the use of debt rather than equity funds to finance a given venture may well in- crease the expected return to the owners,but only at the cost of in- creased dispersion of the outcomes. Under these conditions the profit outcomes of alternative investment and financing decisions can be compared and ranked only in terms of a subjective "utility function"of the owners which weighs the expected yield against other characteristics of the distribution.Accordingly,the extrapolation of the profit maximization criterion of the certainty model has tended to evolve into utility maximization,sometimes explicitly, more frequently in a qualitative and heuristic form.5 The utility approach undoubtedly represents an advance over the certainty or certainty-equivalent approach.It does at least permit us 4 Those who have taken a "case-method"course in finance in recent years will recall in this connection the famous Liquigas case of Hunt and Williams,19,pp.193-96]a case which is often used to introduce the student to the cost-of-capital problem and to poke a bit of fun at the economist's certainty-model. 5 For an attempt at a rigorous explicit development of this line of attack,see F.Modigliani and M.Zeman [14]. This content downloaded from 202.120.21.61 on Thu,30 Nov 201707:07:36 UTC All use subject to http://about.jstor.org/termsMODIGLIANI AND MILLER: THEORY OF INVESTMENT 263 as large and as direct an influence on the rate of investment as this analysis would lead us to believe. At the microeconomic level the cer- tainty model has little descriptive value and provides no real guidance to the finance specialist or managerial economist whose main problems cannot be treated in a framework which deals so cavalierly with uncer- tainty and ignores all forms of financing other than debt issues.4 Only recently have economists begun to face up seriously to the prob- lem of the cost of capital cum risk. In the process they have found their interests and endeavors merging with those of the finance specialist and the managerial economist who have lived with the problem longer and more intimately. In this joint search to establish the principles which govern rational investment and financial policy in a world of uncer- tainty two main lines of attack can be discerned. These lines represent, in effect, attempts to extrapolate to the world of uncertainty each of the two criteria-profit maximization and market value maximization- which were seen to have equivalent implications in the special case of certainty. With the recognition of uncertainty this equivalence vanishes. In fact, the profit maximization criterion is no longer even well defined. Under uncertainty there corresponds to each decision of the firm not a unique profit outcome, but a plurality of mutually exclusive outcomes which can at best be described by a subjective probability distribution. The profit outcome, in short, has become a random variable and as such its maximization no longer has an operational meaning. Nor can this difficulty generally be disposed of by using the mathematical expecta- tion of profits as the variable to be maximized. For decisions which affect the expected value will also tend to affect the dispersion and other characteristics of the distribution of outcomes. In particular, the use of debt rather than equity funds to finance a given venture may well in- crease the expected return to the owners, but only at the cost of in- creased dispersion of the outcomes. Under these conditions the profit outcomes of alternative investment and financing decisions can be compared and ranked only in terms of a subjective "utility function" of the owners which weighs the expected yield against other characteristics of the distribution. Accordingly, the extrapolation of the profit maximization criterion of the certainty model has tended to evolve into utility maximization, sometimes explicitly, more frequently in a qualitative and heuristic form.5 The utility approach undoubtedly represents an advance over the certainty or certainty-equivalent approach. It does at least permit us 4 Those who have taken a "case-method" couirse in finance in recent years will recall in this connection the famous Liquigas case of Hunt and Williams, 19, pp. 193-961 a case which is often used to introduce the student to the cost-of-capital problem and to poke a bit of fun at the economist's certainty-model. 6 For an attempt at a rigorous explicit development of this line of attack, see F. Modigliani and M. Zeman [141. This content downloaded from 202.120.21.61 on Thu, 30 Nov 2017 07:07:36 UTC All use subject to http://about.jstor.org/terms