What is the M&M Theorem?
The M&M Theorem, or the Modigliani-Miller Theorem, is one of the most important
theorems in corporate finance. The theorem was developed by economists Franco
Modigliani and Merton Miller in 1958. The main idea of the M&M theory is that
the capital structure of a company does not affect its overall value.
The first version of the M&M theory was full of limitations as it was developed under the
assumption of perfectly efficient markets in which the companies do not pay taxes while
there are no bankruptcy costs of asymmetric information. Subsequently, Miller and
Modigliani developed the second version of their theory by including taxes, bankruptcy
costs, and asymmetric information.
The M&M Theorem in Perfectly Efficient Markets
It is the first version of the M&M Theorem with the assumption of perfectly efficient
markets. The assumption implies that the companies operating in the world of perfectly
efficient markets do not pay any taxes, the trading of securities is executed without any
transaction costs, bankruptcy is possible but there are no bankruptcy costs, and the
information is perfectly symmetrical.
Proposition 1 (M&M I):
Where:
• V U = Value of the unlevered firm (financing only through equity)
• V L = Value of the levered firm (financing through a mix of debt and equity)
The first proposition essentially claims that the company’s capital structure does not
impact its value.
Since the value of a company is calculated as the present value of future cash flows, the
capital structure cannot affect it. Also, in perfectly efficient markets, companies do not
pay any taxes. Therefore, the company with a 100% leveraged capital structure does not
obtain any benefits from tax-deductible interest payments.
Proposition 2 (M&M I):
Where:
• r E = Cost of levered equity
• r a = Cost of unlevered equity
• r D = Cost of debt
• D/E = Debt-to-equity ratio
The second proposition of the M&M Theorem states that the company’s cost of equity is
directly proportional to the company’s leverage level. The increase in leverage level
induces higher default probability to a company. Therefore, investors tend to demand a
higher cost of equity (return) to be compensated for additional risk.
M&M Theorem in the Real World
Conversely, the second version of the M&M Theorem was developed to better suit real-
world conditions. The assumptions of the newer version imply that companies pay taxes;
there are transaction, bankruptcy, and agency costs; as well as the information is not
symmetrical.
Proposition 1 (M&M II):
Where:
• t c = Tax rate
• D = Debt
The first proposition states that tax shields that resulted from the tax-deductible interest
payments make the value of a levered company higher than the value of an unlevered
company. The main rationale behind the theorem is that tax-deductible interest
payments positively affect a company’s cash flows. Since a company’s value is
determined as the present value of the future cash flows, the value of a levered company
must increase.
Proposition 2 (M&M II):
Similar to the second proposition under the assumption of perfectly efficient markets,
the second proposition for the real-world condition states that the cost of equity has a
directly proportional relationship with the leverage level.
Nonetheless, the presence of tax shields affects the relationship by making the cost of
equity less sensitive to the leverage level. Although the extra debt still increases the
chance of a company’s default, investors are prone to the company taking additional
leverage as it creates the tax shields that boost its value.
