Title: Summary Report on Modigliani-Miller Theorem
Introduction: The Modigliani-Miller Theorem, formulated by Franco Modigliani and Merton Miller in the
1950s, is a fundamental concept in corporate finance and capital structure theory. This theorem
explores the relationship between a firm's capital structure, its cost of capital, and its overall value. The
theorem's central premise is that, under certain idealized assumptions, the value of a firm is
independent of its capital structure. This summary report delves into the key aspects and implications of
the Modigliani-Miller Theorem.
Key Assumptions:
Perfect Capital Markets: The Modigliani-Miller Theorem assumes the existence of perfect capital
markets, where there are no taxes, transaction costs, or information asymmetries. Investors have access
to the same information and can trade securities without any restrictions.
No Financial Distress Costs: The theorem assumes that there are no financial distress costs, meaning
that bankruptcy does not impose any costs on the firm, such as legal fees, lost business opportunities, or
damage to the firm's reputation.
Homogeneous Expectations: Investors and managers have the same expectations regarding the firm's
future cash flows and risk.
Implications:
Irrelevance of Capital Structure: The central proposition of the Modigliani-Miller Theorem is that, under
these idealized assumptions, the firm's value is independent of its capital structure. In other words, it
does not matter whether a firm is financed with debt, equity, or a combination of both; its total value
remains the same.
Cost of Capital: The theorem suggests that the cost of capital is also unaffected by the firm's capital
structure. This implies that the weighted average cost of capital (WACC) remains constant, regardless of
the proportion of debt and equity used to finance the firm.
Arbitrage: In a world with perfect capital markets, investors would engage in arbitrage activities to
maintain their desired risk-return profiles. If a firm's capital structure were to change (e.g., from allequity to a mix of debt and equity), investors would adjust their portfolios accordingly to maintain their
desired risk exposure.
Market Value of Leveraged and Unleveraged Firms: The theorem suggests that the market value of a
leveraged firm (one with debt) and an unleveraged firm (one without debt) can be the same if the
capital structure change does not alter the firm's cash flows or risk.
Critiques and Real-World Considerations:
Imperfect Markets: In reality, capital markets are not perfect, and various factors such as taxes,
transaction costs, and information asymmetries can influence a firm's optimal capital structure.
Financial Distress Costs: Financial distress costs, such as bankruptcy-related expenses and the loss of
business opportunities, can be significant and may favor a more conservative approach to capital
structure.
Taxes: Corporate taxes can create an advantage for debt financing, as interest payments are taxdeductible, making debt cheaper than equity.
Agency Costs: The presence of conflicts of interest between shareholders and management may affect
the firm's capital structure choices.
Conclusion: The Modigliani-Miller Theorem provides valuable insights into the theoretical relationship
between a firm's capital structure and its value. However, it should be applied with caution in real-world
scenarios where assumptions like perfect capital markets do not hold. Managers must consider a range
of factors, including taxes, financial distress costs, and agency issues, when determining the optimal
capital structure for their firm. Nevertheless, the theorem remains a foundational concept in corporate
finance, guiding discussions and research on capital structure decisions.