The Modigliani-Miller Theorem (M&M), also known as the capital structure irrelevance principle, is a theory that suggests that the value of a company is not affected by its financing decisions, assuming perfect markets and no taxes or bankruptcy costs. This means that the total value of a company remains the same, regardless of whether it is financed through equity or debt.
The theorem was developed by Franco Modigliani and Merton Miller in the 1950s and 1960s and is based on the assumption of a perfect market where investors have all the necessary information and can trade freely without transaction costs or taxes. In this scenario, the cost of capital for a company is independent of its capital structure, as investors are indifferent to the mix of debt and equity used to finance the company.
The theorem proposes that in the absence of taxes and other costs, a company can increase its value by leveraging its capital structure with debt financing since debt is cheaper than equity due to the tax deductibility of interest payments. However, this increase in value is offset by the increased risk of bankruptcy associated with higher levels of debt, leading to a trade-off between the benefits and costs of debt financing.
While the Modigliani-Miller Theorem has been widely studied and debated, it is important to note that real-world markets are not perfect, and taxes, transaction costs, and bankruptcy costs do exist. As a result, the theorem is more of a theoretical framework than a practical guide for making financing decisions. Nonetheless, the theorem has influenced the development of modern financial theory and has contributed to the understanding of the relationship between a company’s financing decisions and its value.
