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Modigliani and Miller Theory
Modigliani and Miller Theory
In 1958, Modigliani and Miller presented a theory supporting the irrelevance of capital structure
in firms, when considering the market value of the company and wellbeing of both shareholders
and debtholders. In their point of view, if markets are efficient the source of financing should not
be relevant and the way to increase firm value is by earning more and it also depends on the risk
incurred by the firm.
In their second proposition, Modigliani and Miller conclude that increments in debt/equity ratio
leads to shareholders also increasing their required return due to the fact that they are incurring in
higher risk.
Considering the fact that this proposition does not include taxes and other costs, the weighted
average cost of capital is constant even if the firm’s capital structure changes since tax benefits
will cause the weighted average cost of capital to remain constant. Moreover, the irrelevance of
financing through debt means that the share price is not influenced by the capital structure.
Although the theory presented by Modigliani and Miller has its flaws, mainly due to unrealistic
assumptions which are hard to apply in real world situations, by understanding what is not
important we can also understand what should be important in capital structure. From their
theorem, we can comprehend that by relaxing an assumption we can then look for the factors that
do contribute to an optimal capital structure and how they will impact the optimal ratio of
debt/equity.
M&M World with taxes:
When taxes are considered in Modigliani and Miller’s theory, there are changes in their
propositions which lead to different conclusions.
In their first proposition, relaxing the assumption of a world without taxes leads to the
conclusion that there are advantages regarding the use of leverage (debt) which comes from tax
benefits, i.e., higher amounts of debt lead to higher tax deductions. This means that a firm will
benefit infinitely by increasing their amount of debt, given that the assumption of inexistent
bankruptcy costs is not relaxed.
From their second proposition we can also observe significant changes, even though the fact
that shareholder’s required return will increase with higher amounts of debt is not relaxed. By
including taxes, financing through debt becomes cheaper causing the weighted average cost of
capital to drop and reaching the conclusion that the optimal capital structure is at a level where
the firm is only financed by debt.
Criticism
The Modigliani-Miller theory of capital structure was criticized because the assumption that
capital markets are perfect is completely unrealistic. The arbitrage, as proof of the Modigliani-
Miller theory, was also strongly criticized. If there are no perfect capital markets, the arbitrage
will be useless because a levered and an unlevered firm within the same class of business risk
will have different market values.
The reasons why arbitrage does not allow market equilibrium in real life are as follows:
Transaction costs: If there are transactions costs, buying stock will require bigger initial
investments, but the return remains the same. Therefore, the market value of a levered
firm will be higher than an unlevered one, assuming that both of them are within the
same class of business risk.
Cost of Borrowing: The cost of borrowing is not the same for individuals and firms. The
cost of borrowing depends on the individual credit rating of the borrower.
Institutional Constraints: Institutional investors slow down arbitrage because they limit
the use of financial leverage by their clients.
Bankruptcy cost: The higher the financial leverage, the higher is the probability of
bankruptcy. Therefore, bankruptcy costs have a strong influence on firms.
Many critics of the Modigliani-Miller theory of capital structure believe that assumptions are
unrealistic and that the market value of a firm as well as WACC depends on financial leverage.