Construct · 1 fields · 3 citations

Modigliani-Miller theorem: a standalone construct

One name. One construct. A landmark on the map.

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Modigliani-Millertheorem1 CONSTRUCTMM theoremM&M 1958 · IRRELEVANCE

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Corporate finance

A firm's value is independent of its capital structure under idealized conditions

Franco Modigliani and Merton H. Miller established the theorem in 1958 in The American Economic Review, showing that, under a set of idealized conditions (no taxes, no bankruptcy or transaction costs, and investors and firms able to borrow at the same rate in an efficient market), the total market value of a firm does not depend on how it is financed, that is, on the mix of debt and equity it uses to fund its operations. Their first proposition holds that this value is set by the firm's real assets and expected earnings alone, while their second proposition holds that the return shareholders require rises in proportion to the firm's reliance on debt, so that cheaper debt and costlier equity offset one another and leave the overall cost of capital unchanged. In a 1963 correction the authors added corporate income taxes, showing that when interest payments are tax deductible the value of a firm that borrows rises by the value of the interest tax shield, and Miller revisited and extended the propositions in a 1988 retrospective. The construct is a landmark of corporate finance because it functions as a baseline: by specifying the frictionless world in which financing choices carry no value, it isolates the specific market imperfections, such as taxes, the costs of financial distress, and agency costs, that a firm's financing decisions can then be traced to.[1][2][3]

Unit
A theorem in corporate finance whose object is a firm's total market value and its invariance to the debt-to-equity financing mix under idealized conditions
Recovery means
Not applicable
Measured by
Assessed empirically by relating firm market value or the weighted cost of capital to leverage ratios and testing for the predicted invariance, with observed departures attributed to taxes, financial distress, and agency frictions

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Nearby constructs

capital structure4 names · 6 citationsjangle · one leverage choice, rival theoriesleverage6 fields · 15 citationsjingle · one name, six constructspecking order2 fields · 4 citationsjingle · one word, two constructs

References

  1. Modigliani, F., & Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. The American Economic Review, 48(3), 261–297.
  2. Modigliani, F., & Miller, M. H. (1963). Corporate income taxes and the cost of capital: A correction. The American Economic Review, 53(3), 433–443.
  3. Miller, M. H. (1988). The Modigliani-Miller propositions after thirty years. Journal of Economic Perspectives, 2(4), 99–120. https://doi.org/10.1257/jep.2.4.99

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