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Understanding Capital Structure Theory: Modigliani and
Miller
Checklist Description
This checklist describes the ModiglianiMiller theorem of capital
structure, devised by Franco Modigliani andMerton Miller in 1958,
which set out the cornerstones for modern thinking on capital
structure and corporatefinance.
Definition
The ModiglianiMiller theorem states that, in the absence of
taxes, bankruptcy costs, and asymmetricinformation, and in an
efficient market, a companys value is unaffected by how it is
financed, regardless ofwhether the companys capital consists of
equities or debt, or a combination of these, or what the
dividendpolicy is. The theorem is also known as the capital
structure irrelevance principle.
A number of principles underlie the theorem, which holds under
the assumption of both taxation and notaxation. The two most
important principles are that, first, if there are no taxes,
increasing leverage bringsno benefits in terms of value creation,
and second, that where there are taxes, such benefits, by way of
aninterest tax shield, accrue when leverage is introduced and/or
increased.
The theorem compares two companiesone unlevered (i.e. financed
purely by equity) and the other levered(i.e. financed partly by
equity and partly by debt)and states that if they are identical in
every other way thevalue of the two companies is the same.
As an illustration of why this must be true, suppose that an
investor is considering buying one of either anunlevered company or
a levered company. The investor could purchase the shares of the
levered company,or purchase the shares of the unlevered company and
borrow an equivalent sum of money to that borrowedby the levered
company. In either case, the return on investment would be
identical. Thus, the price of thelevered company must be the same
as the price of the unlevered company minus the borrowed sum
ofmoney, which is the value of the levered companys debt. There is
an implicit assumption that the investorscost of borrowing money is
the same as that of the levered company, which is not necessarily
true in thepresence of asymmetric information or in the absence of
efficient markets. For a company that has riskydebt, as the ratio
of debt to equity increases the weighted average cost of capital
remains constant, but thereis a higher required return on equity
because of the higher risk involved for equity-holders in a company
withdebt.
Advantages
In practice, its fair to say that none of the assumptions are
met in the real world, but what the theoremteaches is that capital
structure is important because one or more of the assumptions will
be violated.
By applying the theorems equations, economists can find the
determinants of optimal capital structureand see how those factors
might affect optimal capital structure.
Disadvantages
Modigliani and Millers theorem, which justifies almost unlimited
financial leverage, has been used toboost economic and financial
activities. However, its use also resulted in increased complexity,
lackof transparency, and higher risk and uncertainty in those
activities. The global financial crisis of 2008,which saw a number
of highly leveraged investment banks fail, has been in part
attributed to excessiveleverage ratios.
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More Info
Books:
Brealey, Richard A., Stewart C. Myers, and Franklin Allen.
Principles of Corporate Finance. 9th ed.
Boston, MA: McGraw-Hill/Irwin, 2008. Stewart, G. Bennett. The
Quest for Value: A Guide for Senior Managers. New York:
HarperBusiness,
1991.
Articles:
Miles, James A., and John R. Ezzell. The weighted average cost
of capital, perfect capital markets,and project life: A
clarification. Journal of Financial and Quantitative Analysis15:3
(September 1980):719730. Online at: dx.doi.org/10.2307/2330405
Modigliani, Franco, and Merton H. Miller. The cost of capital,
corporation finance, and the theoryof investment. American Economic
Review48:3 (June 1958): 261297. Online at:
www.jstor.org/stable/1809766
Modigliani, Franco, and Merton H. Miller. Corporate income taxes
and the cost of capital: A
correction. American Economic Review53:3 (June 1963): 433443.
Online at: www.jstor.org/stable/1809167
See Also
Best Practice
Capital Structure: Perspectives Optimizing the Capital
Structure: Finding the Right Balance between Debt and Equity
Checklists
Investors and the Capital StructureThinkers
Franco Modigliani Merton Miller
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