Background and assumptions
In their 1958 American Economic Review paper, Modigliani and Miller analysed financing under a perfect market: no taxes, bankruptcy costs, transaction costs or asymmetric information, and borrowing at the same rate for firms and individuals. Both later received the Nobel Prize in economics.
The propositions
- Proposition I (irrelevance): firms with the same business risk have the same value whether levered or not, because investors can replicate leverage on their own ("homemade leverage") and arbitrage removes any gap.
- Proposition II: the cost of equity rises linearly with the debt-equity ratio, leaving the weighted average cost of capital unchanged.
- 1963 tax correction: when interest is tax deductible, the debt tax shield adds value, implying in the extreme that all-debt financing is optimal.
Significance and limits
Taxes, financial distress, agency costs and information problems mean the theorem does not hold literally. Its value is as a benchmark that shows which frictions make financing matter, leading to the trade-off and pecking order theories.
References
- Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. American Economic Review, 48(3), 261-297.
- Modigliani, F., & Miller, M. H. (1963). Corporate income taxes and the cost of capital: A correction. American Economic Review, 53(3), 433-443.
- Brealey, R. A., Myers, S. C., & Allen, F. (2020). Principles of Corporate Finance (13th ed.). McGraw-Hill.