Lintner started his analysis with the M&M paper (written by F. Modigliani and M. Miller), even though he knew that at an extent, the theory defended in this paper- independence between a firm value and its financial policy- was inaccurate. Indeed, due to the importance of uncertainty in the real world, he was convinced that financial policy would affect the firms by affecting the riskiness of its future profits.
As a result, he developed his theory of the “valuation of risky assets” -which led him to theCAPM- and he modified the well-known formula of future earnings by introducing certainty equivalents for troublesome expected values.
Lintner’s model of asset pricing was focused on the independent risk unique to a given firm taking into account only the effect of the covariance. His main conclusion for the CAPM, was that the solution was to hold a widely diversified portfolio (both high and low variances stock) to reduce the risk of an investment.
A for Tom. The writing is OK, but there are some problems with your description in the third paragraph.
ReplyDeleteIdeas like Modigliani and Miller bug students, because they are clearly unrealistic, and students focus on the lack of realism.
Instead, you should view Modigliani and Miller as drawing a line in the sand: on one side are the situations in which capital structure won't matter, and on the other side are the situations where it might. Just because the real world in on the latter side isn't relevant. What is relevant is that no one even knew there was a dividing line before Modigliani and Miller pointed it out. Now, if we find a real world situation where we'd think that capital structure should matter, but doesn't seem to, then we can move that dividing line, or talk about why it's fuzzy or flexible in that direction.
Lintner kind of went off in the wrong direction on his stock valuation problem. He thought Modigliani and Miller had to be wrong. And, he thought he could find their error in the variance of a firm's returns that is idiosyncratic to that firm. But, the message of the CAPM is that this is the risk that doesn't matter, because you can and should diversify it away. What's left is the covariance of the firm's returns with those of the market. Lintner got this result, but probably suffered some cognitive dissonance, because it actually ends up supporting Modigliani and Miller: capital structure doesn't matter, but covariance with the market does. Mehrling asserts that this led to delays in Lintner releasing his paper.