Modigliani-Miller Theorem

Modigliani-Miller Theorem

Overview

The Modigliani-Miller theorem (1958) establishes that in perfect capital markets, firm value is independent of capital structure. This irrelevance result serves as the benchmark — every real-world reason capital structure matters is a violation of MM's assumptions.

When to Use

• Evaluating whether a financing decision creates or destroys value
• Identifying which market imperfections make capital structure relevant
• Calculating the value of the tax shield from debt
• Teaching or analyzing the logical foundations of capital structure theory

When NOT to Use

• As a literal prescription — real markets are never frictionless
• When the analysis requires explicit bankruptcy cost modeling (use tradeoff theory)
• For financial institutions where capital structure is regulated

Assumptions

IRON LAW: MM irrelevance holds ONLY in perfect markets — every
real-world deviation (taxes, bankruptcy costs, agency costs) makes
capital structure matter. MM is the null hypothesis, not the answer.

Key assumptions (for irrelevance):

1. No taxes (corporate or personal)
2. No bankruptcy costs or financial distress costs
3. No agency costs — managers act in shareholders' interest
4. Symmetric information — insiders and outsiders know the same things
5. Individuals and firms borrow at the same rate

Methodology

Step 1 — State MM Propositions

• Proposition I (no tax): VL = VU — firm value is independent of leverage
• Proposition II (no tax): Re = R0 + (D/E)(R0 - Rd) — cost of equity rises linearly with leverage