modigliani-miller theorem

Modigliani-Miller Theorem

A study of whether there exists an optimal capital structure that minimizes the discount rate required to value a firm. In the 1958 theory, firm value was shown to be unrelated to the use of debt. However, in the 1963 revised model, when corporate taxes are considered, an optimal capital structure that minimizes the firm's discount rate exists, and firm value is greatest under this optimal capital structure.

The propositions below assume perfect capital markets and homogeneous risk classes.

1958 MM

Based on the basic assumptions of the MM theory, the following results were derived between the value of a levered firm VL and the value of an unlevered firm VU, and are commonly summarized as three propositions.

Proposition 1 Changes in capital structure, i.e., whether debt is used, have no effect on firm value or the weighted average cost of capital.

Proposition 2 As leverage increases, the cost of equity (ke) rises, completely offsetting the cheap-debt effect.

Proposition 3 The cut-off rate for new investment projects is determined independently of the financing method.

Criticism

1. Corporate taxes exist in reality.
2. Market imperfections exist in reality.
3. The borrowing capacity of individuals and firms differs significantly.
4. Frictional factors such as transaction costs exist.

1963 MM Revised Model

In the 1963 revised model, the assumption that corporate taxes exist was added to the basic assumptions. The interest expense tax shield arising from the use of debt under corporate taxes was considered. As a result, it reached the revised conclusion that an optimal capital structure exists.

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Topics: economic theory,debt
Category: Wiki/Economy