The Modigliani-Miller Theorem: still omnipresent after 60 years

If one would ask a random finance student to cite one basic financial theorem, chances are quite high that he or she mentions the likes of Franco Modigliani and Merton Miller, authors of the famous Modigliani-Miller Theorem. To be fair, this cannot be too surprising since the theorem, first published in 1958, provided the foundation for more than half a decade of additional research in the area of corporate finance. Although it relies on quite stringent assumptions, the M&M theorem provides a valuable framework that is used to explain the decisions companies make with regard to their finance mix. To understand how it works, one should look a bit more closely.

Simply put, Modigliani and Miller claim that the value of a company doesn’t depend on the way it is financed. Whether a company relies only on equity financing or it uses a mix of debt and equity, its value stays the same. This is why the M&M theorem is also known as the capital structure irrelevance principle. Important to notice however, is the fact that this bold statement only applies under certain conditions. It is to say, in a Modigliani-Miller world there are no agency costs, no bankruptcy costs and no taxes. Furthermore economic agents can count on perfect information and prices of assets correctly reflect all available information sources. In this case, opting for more debt financing, which is available at a lower cost than equity, increases the expected return for shareholders. But is also involves more risk for shareholders, which makes them demand higher returns, raising the cost of equity. No matter which debt ratio is chosen, the weighted average cost of capital therefor will stay the same, at least if the conditions previously mentioned apply.  Needless however to say that in the real world, these criterions do not hold. With respect to the existence of taxes, the M&M theorem can be adapted by taking into account the tax benefit of debt. In this case, the value of a company can be increased by adopting a higher debt ratio. But the effect of the other conditions is not as easy to estimate.

In fact, this is where the significance of the Modigliani-Miller theorem really lies. It is clear that in reality the necessary assumptions that are used, will probably never be valid, not even in France. But the theorem was never developed to ‘prove’ that financial structure is really irrelevant. Actually, by closely looking at how the theorem is affected when the imposed conditions are not fulfilled, one can understand the trade-off that exists between debt and equity financing in imperfect markets. It is this continuously evolving trade-off between benefits and costs created by market imperfections that constantly drives the optimal debt level of a company, for example through tax benefits and bankruptcy costs. Taking this into account, it is fairly safe to say financial managers today still take their decisions with Modigliani and Miller in mind.