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Modigliani-Miller Theorem

Definition - What does Modigliani-Miller Theorem mean?

The Modigliani-Miller theorem states that the valuation of a firm is not affected by the capital structure of a company in a market without taxes, government and agency fees and asymmetric information. Therefore, the theorem is also known as the capital structure irrelevance principle as it is irrelevant whether a firm is highly leveraged or carries low debt because the market value of a firm will be determined by the profits generated by its assets.

Divestopedia explains Modigliani-Miller Theorem

The Modigliani-Miller theorem forms the basis of modern day thought in the corporate financial structure in which a firm can replicate or undo its financial actions and maintain market value based on the profit generated by its assets.

The theorem proposes that:

  • The market value of a leveraged firm versus an unleveraged firm is not affected if the profits and future returns are the same. The weighted average cost of capital (WACC) is not affected by the firm's leverage.
  • The market value is not dependent on a firm’s dividend policy; therefore, the value is unaffected whether a firm chooses to pay dividends or reinvest its profits.
  • The value of the firm is independent of the financial policy of the company. The firm will still have good performance whether it is financed by equity, debt or a combination of the two.Therefore, regardless of the risk associated with investment, the method of financing does not determine the market value.
  • The market value is not affected by a firm's debt-equity ratio.

The theorem assumes that:

  • The financial market operates without taxes.
  • Information is symmetrical; therefore, a private investor will have access to the same market information as a corporation would and that the borrowing rates would be the same for both.
  • Market frictions, such as transactional costs and bankruptcy costs, are excluded.
  • Financial policy does not divulge any information.

Lastly, the theorem explores the idea of "even footed-ness" among firms, which questions the types of friction, such as transaction costs and legal constraints, that would allow some firms to have access to different market opportunities or information. This idea has been used to aid in global economics research in order to resolve economic problems, such as monetary and international economics and public finance.

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