What does Modigliani-Miller say about capital structure irrelevance?

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AcadiFi · Accepted Answer

Modigliani-Miller (1958) Proposition I states that in a frictionless market, the value of a firm is independent of its capital structure. The argument rests on arbitrage: if levered and unlevered firms with identical operating cash flows had different values, investors could replicate the levered position via homemade leverage (borrowing on personal account) and arbitrage the difference away.

Formally, V_L = V_U where V_L is the levered firm value and V_U is the unlevered. Firm value depends only on the operating cash flows and business risk, discounted at the unlevered cost of capital. Changing debt-equity mix simply repackages the same cash flow stream among claimants.

Assumptions (strict and unrealistic): no taxes, no bankruptcy costs, no agency costs, no transaction costs, symmetric information, equivalent borrowing rates for individuals and firms, and complete capital markets.

For Pendleford Group, MM is the theoretical baseline. Real-world deviations from MM assumptions generate the trade-offs CFOs manage: tax shields favor debt (MM with taxes gives V_L = V_U + tD), bankruptcy costs penalize excessive leverage, agency conflicts between debtholders and equityholders create costs, and information asymmetry affects issuance pricing.

The value of MM is not as a policy prescription but as a benchmark: any claim that a specific capital structure creates value must identify which MM assumption is violated. CFOs who 'create value through capital structure' are exploiting tax shields, signaling, agency rebalancing, or market timing.

What does Modigliani-Miller say about capital structure irrelevance?

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