Modigliani-Miller Theorem
The Modigliani-Miller theorem (M&M) states that the market value of a company is correctly calculated as the present value of its future earnings and its underlying assets, and is independent of its capital structure.
At its most basic level, the theorem argues that, with certain assumptions in place, it is irrelevant whether a company finances its growth by borrowing, by issuing stock shares, or by reinvesting its profits.
Developed in the 1950s, the theory has had a significant impact on corporate finance.
Definition: The Modigliani-Miller Theorem (M&M Theorem) states that in a perfect market, a company's market value should be correctly calculated as the present value of its future earnings and underlying assets, and it is independent of its capital structure. In other words, whether a company finances its growth through debt, issuing equity, or reinvesting profits does not affect its market value.
Origin: The Modigliani-Miller Theorem was proposed by Franco Modigliani and Merton Miller in 1958. Their research had a significant impact on corporate finance theory in the 1950s and earned them the Nobel Prize in Economics in 1990.
Categories and Characteristics: The Modigliani-Miller Theorem is primarily divided into two propositions:
1. Proposition I: In the absence of taxes, bankruptcy costs, and asymmetric information, a company's capital structure does not affect its market value.
2. Proposition II: When considering taxes, debt financing can provide a tax shield, thereby increasing the company's market value.
These propositions are characterized by a set of strict assumptions, such as no market frictions, no taxes, and no bankruptcy costs.
Specific Cases:
1. Case One: Suppose Company A and Company B are in the same industry, with identical assets and future earnings expectations. Company A is entirely equity-financed, while Company B is financed with 50% equity and 50% debt. According to M&M Theorem Proposition I, in the absence of taxes and other market frictions, the market value of both companies should be the same.
2. Case Two: Suppose Company C operates in a tax environment and increases its debt financing to utilize the tax shield. According to M&M Theorem Proposition II, the market value of Company C will increase due to the presence of the tax shield.
Common Questions:
1. Q: Why does a company's capital structure affect its market value in reality?
A: Because real markets have taxes, bankruptcy costs, asymmetric information, and other factors that influence a company's capital structure decisions and market value.
2. Q: Do the assumptions of the Modigliani-Miller Theorem hold in reality?
A: In most cases, these assumptions do not fully hold in reality, but the theorem provides a theoretical foundation for understanding the impact of capital structure.
