This lesson examines the foundational Modigliani-Miller (MM) theorem, which argues that under perfect market conditions, a firm’s capital structure is irrelevant to its value. It covers Proposition I and Proposition II and explores the key assumptions of the model.

• The Irrelevance Proposition (MM Proposition I – No Taxes): The modern theory of capital structure began with the seminal work of Franco Modigliani and Merton Miller. Their first proposition, often called the capital structure irrelevance theorem, states that in a perfect capital market, the market value of a firm is independent of its capital structure. Under these conditions, a firm’s value is determined exclusively by the earning power and risk of its underlying assets, not by how it chooses to finance them. The formula is: VL = VU (the value of a levered firm equals the value of an unlevered firm).

• MM Proposition II (No Taxes): This proposition addresses the cost of capital. It states that the cost of equity (Ke) of a levered firm increases in direct proportion to its debt-to-equity ratio (D/E). The increase in the cost of equity, which reflects the higher financial risk borne by shareholders, perfectly offsets the benefit of using cheaper debt. As a result, the firm’s WACC remains constant regardless of leverage.

  • Formula: Ke = K0 + (K0 – Kd) × (D/S) , where K0 is the WACC, Kd is the cost of debt, D is the market value of debt, and S is the market value of equity.

• The Logic of “Homemade Leverage”: The MM theorem is based on the idea that if investors are dissatisfied with a firm’s leverage, they can replicate or undo it in their personal portfolios by borrowing or lending at the same rate as the firm. This “homemade leverage” makes the firm’s capital structure decision irrelevant to the investor.

• Key Assumptions of the MM Model: The MM theorem relies on strict assumptions of a “perfect” market, including: no corporate or personal taxes, no transaction costs, no bankruptcy costs, symmetric information (managers and investors have the same information), and rational investors with the ability to borrow without restrictions at par with the firm.