Modigliani-Miller and Capital Structure Theory

Modigliani and Miller (MM) are great academics in economics and finance who broadly studied the impact of capital structure on a company’s value.

MM Proposition 1 without Taxes: Capital Structure Irrelevance

Under Prop 1, MM theorized that in a tax free environment, with perfect information and no costs for financial distress, capital structure is irrelevant and changing a firm’s capital structure will not impact the firm’s valuation.

A unique characteristic of Prop 1 is that it assumes that operating earnings are split equally between stock and bondholders; in other words, neither has a higher residual claim on earnings.

MM Proposition 2 without Taxes: Increasing Financial Leverage Increases the Cost of Equity

Under Prop 2, MM assumes that the cost of equity is a linear function of the company’s debt to equity ratio.

A key distinction from the assumptions of Prop 1 is that Prop 2 assumes that debt has a superior claim to earnings than equity, which gives debt a lower cost than equity.

In return for their increased risk, equity holders receive a larger proportion of profit.  However, increased equity returns are offset by an increased required return on equity (this is reflected by the cost of equity being a linear function of a company’s debt to equity ratio).  Therefore the leveraged firm is valued the same as the unleveraged firm.

MM with Taxes

In most countries, interest is tax deductible.

When MM assumes there are no costs for financial distress, the value of the firm increases as it takes on more debt and under this scenario the firm maximizes value using 100% debt capitalization.

Relaxing MM Assumptions

The scenarios presented by MM are not necessarily reflective of business reality.  Additional factors for consideration include:

  • Financial Distress: as a firm assumes more debt (i.e. increases its financial leverage), its bankruptcy risk increases.  This increased risk should be factored in to any analysis.
  • Agency Costs: these are the costs incurred by stockholders to monitor company managers; agency costs are increased when monitoring mechanisms fail and equity value losses are absorbed.
  • Asymmetric Information: MM assumes perfect information, but company managers commonly know more about the firm than the investing public.  This is asymmetric information.
  • The pecking order theory states that company management prefers to use internal financing (cash on hand, retained earnings) as these sources are not as readily visible to the public as stock and bond offerings, which invite scrutiny.  Typically management is biased to debt, unless the equity is considered overvalued.

Static Trade-Off Theory

Outside the MM construct, this theory views capital structure as a decision that balances costs and benefits.

Under static trade-off, the company should continue to capitalize itself with debt until the increased costs associated with financial distress exceed the value of the tax shield.

Series NavigationIntroduction to Capital Structure and LeverageEvaluating Capital Structure Policy
  • amir


    Hi, I am Behnam from Iran. I want to request help from you and the world
    community. I am 35 years old and I have a degree in archeology and technical
    certificate in architecture, Jewelry, electricity, carpentry and turning. But
    my job is interior decoration or interior design with 10 years of work

    I have a good and kind wife who is a dentist with 15 years of experience
    and we have 3 children who are studying at different educational levels
    (elementary school, high school and University) with excellent scores and grade
    point average.

    It is now for 5 years that poverty and indigence has engulfed our lives due
    to loss of capital. We are a hardworking family. My wife and I work 16 hours a
    day but we cannot afford our living expenses. Even our government doesn’t support
    us. With don’t have any accommodation or car. It is for 5 years that we haven’t
    been able to go travelling. I wish I could provide a dental office for my wife
    and a company of architecture and interior decoration for myself. I believe
    that if we work in our own company, we will be successful, but we don’t have
    enough money. May I ask you to provide us, for the sake of God and my children,
    with the required money? We promise that by striving hard and working together,
    we will succeed and could give back your money. God bless you! The life has
    become very difficult for us. In this condition, I cannot afford to pay my
    children’s expenses. Please help me! I promise to work hard to get successful
    and repay your money. We are poor but we are not beggars. We have no one to
    borrow money from them. We have lost our friends, because we have no house and
    car. Please help us! Our life depends on your help. You are our last hope. We
    are young and educated forces but unfortunately we don’t have the needed
    capital to use our knowledge. We either don’t have the required conditions to
    get the bank loans. First we trust in the kind and merciful God and then on
    your benefaction.

    Just one year, just one year! 09128890197 09126778462