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Home > Balance Sheets Checklists > Understanding Capital Structure Theory: Modigliani and Miller

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Understanding Capital Structure Theory: Modigliani and Miller


Checklist Description

This checklist describes the Modigliani–Miller theorem of capital structure, devised by Franco Modigliani and Merton Miller in 1958, which set out the cornerstones for modern thinking on capital structure and corporate finance.

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Definition

The Modigliani–Miller theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, a company’s value is unaffected by how it is financed, regardless of whether the company’s capital consists of equities or debt, or a combination of these, or what the dividend policy is. The theorem is also known as the capital structure irrelevance principle.

A number of principles underlie the theorem, which holds under the assumption of both taxation and no taxation. The two most important principles are that, first, if there are no taxes, increasing leverage brings no benefits in terms of value creation, and second, that where there are taxes, such benefits, by way of an interest tax shield, accrue when leverage is introduced and/or increased.

The theorem compares two companies—one unlevered (i.e. financed purely by equity) and the other levered (i.e. financed partly by equity and partly by debt)—and states that if they are identical in every other way the value of the two companies is the same.

As an illustration of why this must be true, suppose that an investor is considering buying one of either an unlevered company or a levered company. The investor could purchase the shares of the levered company, or purchase the shares of the unlevered company and borrow an equivalent sum of money to that borrowed by the levered company. In either case, the return on investment would be identical. Thus, the price of the levered company must be the same as the price of the unlevered company minus the borrowed sum of money, which is the value of the levered company’s debt. There is an implicit assumption that the investor’s cost of borrowing money is the same as that of the levered company, which is not necessarily true in the presence of asymmetric information or in the absence of efficient markets. For a company that has risky debt, as the ratio of debt to equity increases the weighted average cost of capital remains constant, but there is a higher required return on equity because of the higher risk involved for equity-holders in a company with debt.

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Advantages

  • In practice, it’s fair to say that none of the assumptions are met in the real world, but what the theorem teaches is that capital structure is important because one or more of the assumptions will be violated. By applying the theorem’s equations, economists can find the determinants of optimal capital structure and see how those factors might affect optimal capital structure.

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Disadvantages

  • Modigliani and Miller’s theorem, which justifies almost unlimited financial leverage, has been used to boost economic and financial activities. However, its use also resulted in increased complexity, lack of transparency, and higher risk and uncertainty in those activities. The global financial crisis of 2008, which saw a number of highly leveraged investment banks fail, has been in part attributed to excessive leverage ratios.

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Further reading

Books:

  • Brealey, Richard A., Stewart C. Myers, and Franklin Allen. Principles of Corporate Finance. 11th ed. New York: McGraw-Hill, 2013.
  • Stewart, G. Bennett. The Quest for Value: A Guide for Senior Managers. New York: HarperBusiness, 1991.

Articles:

  • Miles, James A., and John R. Ezzell. “The weighted average cost of capital, perfect capital markets, and project life: A clarification.” Journal of Financial and Quantitative Analysis 15:3 (September 1980): 719–730. Online at: dx.doi.org/10.2307/2330405
  • Modigliani, Franco, and Merton H. Miller. “The cost of capital, corporation finance, and the theory of investment.” American Economic Review 48:3 (June 1958): 261–297. Online at: www.jstor.org/stable/1809766
  • Modigliani, Franco, and Merton H. Miller. “Corporate income taxes and the cost of capital: A correction.” American Economic Review 53:3 (June 1963): 433–443. Online at: www.jstor.org/stable/1809167

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